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US Dollar: Expect a Correction if the Euro Crisis Doesn’t Intensify

By , Chief Currency Strategist
17 December 2011 02:13 GMT
US_Dollar_Expect_a_Correction_if_the_Euro_Doesnt_Intensify_body_Picture_5.png, US Dollar: Expect a Correction if the Euro Crisis Doesn’t IntensifyUS_Dollar_Expect_a_Correction_if_the_Euro_Doesnt_Intensify_body_Picture_6.png, US Dollar: Expect a Correction if the Euro Crisis Doesn’t Intensify

Fundamental Forecast for the US Dollar: Neutral

The dollar has two significant obstacles that it must overcome to extend this past week’s impressive run and move on to 11-month highs: a rising tolerance for financial shocks and expectations for a seasonal slump in speculative participation. Lifting the dollar requires an active and extensive fundamental push. Though global rates are closing the positive yield gaps with US benchmarks and diminished growth forecasts are putting the US on very competitive footing; there is still the underlying urge to diversify away from the world’s reserve to avoid a repeat of the 2008 financial market implosion. Without an active, global push for deleverage and risk avoidance; the greenback could spend the remainder of the year in a choppy retracement back into the comfort of broader ranges.

For those FX traders that dabble in the equities markets, the Santa Claus rally should be a familiar term. This references a seasonality effect where capital markets often climb into the final one or two weeks of the year. However, our interest in this episode is the rapid deflation in market participation. We don’t need a ‘risk on’ push to trip up the dollar. A stalled risk aversion move is enough to shake out dollar longs (generally a proxy for foreign demand for Treasuries) that are not committed to a lasting period of turmoil heading into 2012 and thereby a natural correction for the currency. What’s more, in these restrained and balanced market conditions, the masses tend to be more tolerant of both positive and negative headlines that would otherwise spark volatility in most other situations.

That said, the market will be looking out beyond the two-week, year-end period to project the risk that the Euro-area crisis evolves into a global crisis. That forward looking concern will also act to ensure that a dollar unwinding trend would also struggle for momentum. Given this general scenario, it will be very difficult to generate meaningful and consistent trends; but there is a high risk of persistently high volatility. It is more difficult to spark sharp rallies in risk taking against the backdrop of fading growth and lending, yet the scene is perfectly set for acute drops in speculative positioning. The most immediate catalyst for these anxious times Euro Zone developments.

In the past few weeks and months, sentiment itself has contributed the bulk of the weight behind euro selling (leveraging the dollar as its primary counterpart) and risk aversion (playing to the greenback’s safe haven / liquidity appeal). A dramatic loss of confidence in the EU’s ability to bring its troubles to a tidy resolution have driven government bond yields for Italy, Spain and other EU members higher while further diminishing the availability of liquidity for Euro-region banks. The ECB’s unlimited, 36-month repo facility planned for next week would certainly help stabilize liquidity; but that does not get to the root of the problem. Increased lending amongst regional institutions and purchases of government bonds will be forsaken in favor of boosting capital positions ahead of tougher market conditions and regulations.

Alternatively, there is a looming – and difficult to price – risk that one of the rating agencies will deliver on threatened downgrades to important members of the EU or the EFSF lending program. Such a development would further undermine the rescue effort and hasten the spread of financial trouble to the other ill-positioned developed-nation markets. Any significant deterioration in global credit conditions will likely rouse a surprising swell in volatility and demand dollar-based safe haven assets.

As for fundamental developments restricted to the US financial borders, the economic data on tap simply does not carry enough influence to spur anything more than a temporary surge in volatility. Something that should be considered now for future reverence though is the rapid adoption of stimulus amongst other central banks. A bloated Fed balance sheet is looking less and less unique. – JK

---Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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17 December 2011 02:13 GMT