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Dollar Posts Biggest Surge in 18 Months on the Way to 3 Year Highs

By , Chief Currency Strategist
18 May 2013 00:51 GMT
Forex_Dollar_Posts_Biggest_Surge_in_18_Months_on_the_Way_to_3_Year_Highs_body_Picture_5.png, Dollar Posts Biggest Surge in 18 Months on the Way to 3 Year Highs

Dollar Posts Biggest Surge in 18 Months on the Way to 3 Year Highs

Fundamental Forecast for US Dollar: Bullish

The dollar has exploded higher. Since overtaking the 10,600-mark – the midpoint of the past decade’s range – the Dow Jones FXCM Dollar Index (ticker = USDollar) has posted its biggest two-week rally since November 2011. Momentum of this scale is all the more impressive because the benchmark is winning fresh three-year highs with each drive forward. This incredible strength causes a fair amount of confusion (Assess Your Trading IQ) because it seems to contradict our assumptions of how a safe haven – like the greenback – performs when benchmarks for risk appetite are scaling record highs of their own. Dollar traders must understand the root of this apparent fundamental inconsistency, because it will define where we go from here – and reveal how natural retracements can quickly return to this incredible rally.

There is little doubt that the dollar is a safe haven currency – bid when fear escalates to panic and a scramble to liquidity drives capital to Treasuries, US money markets and therefore the dollar. However, the equilibrium between risk and return does not always follow a traditional path. It would seem that ‘risk appetite’ is swelling as developed-world equities (led by the S&P 500) are pressing record highs and the yen crosses (the high dividend investment of the FX world) have advanced 20-30 percent in the span of 8 months. The appetite for yield is there, but it is a forced chase for returns that are themselves at record lows and based on a dubious period of market stability founded on the ambiguous and transient support of the world’s largest central banks.

So, instead of finding an optimal market to invest in (where growth is robust, yields high, capital efficiently seeking out the best wealth generating projects); we are seeing the side effects of ‘moral hazard’. This is a term that describes a state whereby market participations invest under the assumptions that the normal risks that come with their trade are moderated or completely avoided thanks to a source of external support – in this case: central banks. This period of willful disregard has directed us for years, so it is not something that we should immediately try to fade. Yet, the aberrant conditions can continue to build over time. And, just like a market can find itself overstretched on a move; there is also inevitably a point where stimulus-generate confidence hits an extreme.

The dollar’s recent strength may itself be a harbinger of a ‘tipping point’. In the current environment, market participants are investing in anything that provides yield with seemingly little mind of the risks. This is why we see the S&P 500 at record highs, yields on corporate junk bonds at record lows, a wide divergence in yen-based yen crosses and their respective yield differentials, record levels of leverage employed on the NYSE, 15-year lows in open interest for the benchmark S&P 500 big contract and a number of other extraordinary developments. At this point, we are likely seeing a self-sustained vicious cycle whereby the market is growing desperate for a reasonable rate of return and the commensurate risk is building alongside the exposure. Like a technical ‘blow off top’ formation, this is the final stage of a rapid escalation that falls apart rapidly.

How does the dollar fit into all of this? As the scramble for a few extra basis points devolves, the slosh of capital around the world naturally finds a larger proportion in the world’s largest market. This is further true as counterparts to the US introduce policy that curbs capital inflow or discourages it by making driving down their own rates (via stimulus). This relative boost to the dollar has helped lift the currency outside of its normal ‘risk on / risk off’ scheme. That has placed the dollar in a unique position where it has advanced during a period where it would traditionally struggle; and its most favorable conditions still lie ahead.

If we were looking through the scenarios where the dollar would truly capsize, the market’s two dominant themes in investor sentiment and stimulus seem more or less limit bound to the damage that can be done to the currency. It is very unlikely that risk appetite expands rapidly from its current bearings, and a large-scale upgrade of Fed stimulus (and/or significant decrease in its peers’ programs) is just as unlikely. On the contrary, a deleveraging effort that moves away from high-priced and low-yielding assets seems a very high probability. If we were to see a systemic risk aversion move, it revive a dormant value the dollar hasn’t tapped in years. Meanwhile, speculation is building that the QE3 ‘tapering’ may beginwith the next FOMC meeting in June. We will see if this possibility was mentioned in the Fed minutes this week, we’ll measure it through member speeches and the market will simply speculate. – JK

--- Written by: John Kicklighter, Chief 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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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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18 May 2013 00:51 GMT