US Dollar: Six Month Outlook

From a low set in late November, the US dollar spent the first half of 2010 in a steady and inexhaustible rally to 15-month highs. Through the mid-point of the year, the single currency would not even suffer a correction that could be construed as the beginning of a potential reversal. That is, until June rolled around. There are many explanations for the greenback’s mid-year retracement; but no single justification better encompasses the motive to the altered course better than risk appetite itself. In the dollar’s climb through the opening half of the year, there was a disputable argument to be made that the US economy was carving a stronger pace than its many of its global counterparts or that the Federal Reserve would turn to rate hikes before the European Central Bank or Bank of England. However, the true source of the currency’s strength was in its appeal as a safe haven. Given the prevalence of news headlines that warned that the sovereign credit ratings were at risk, China (the leader of the economic and speculative recovery) was overheating and the European Union was fostering its own financial crisis; the need for speculative sanctuary was obvious.

What currency traders must to consider heading into the second half of the year is whether the need for safety could truly dissipate or will it continue to intensify. Furthermore, it is important to establish whether the benchmark currency will maintain its role as the FX market’s preferred safe haven or if that responsibility will be passed on to another currency. And, for a forecast that spans more than a few months, a proper assessment of the US dollar will have to perform analysis that goes beyond the unpredictable nature of speculative interests. Should the underlying current for investor sentiment stabilize, the currency’s performance will fall once again to the seemingly ordinary task of establishing the relative strength of the US economy and its financial markets. What’s more, long-term concerns like potential sovereign credit risks and demand for an alternative reserve currency may start to play a bigger role in the dollar’s bearings.

Shelter from the Storm

The virtues of the US dollar as a safe haven when global conditions start to deteriorate were well established during the height of the 2007-2008 financial crisis. This role has only been furthered cemented into the speculative market’s consciousness with the souring of risk appetite through the first half of this year and the subsequent appreciation of the greenback. Where does the expectation for safety drawn from? For international investors, the most communicable appeal for dollars during periods of uncertainty resides in the supposed safety expected from investing in US treasuries and money market accounts. The sheer depth of these markets along with the untested virtuousness of their ratings (so far) make it a bright beacon for international investors. And, beyond the applicable safe havens in the US market, there is always the cache that the US capital market is one of the most liberal in the world with extensive investor protections. This along with the ‘habit’ of sending funds to the US during times of hardship (similar to how it is done in gold) has maintained the dollar’s buoyancy when the concept of fear is all too real.

Heading into the second half of the year, it may seem that some of the more pressing global financial threats have eased. However, this is more likely a lapse in logical analysis (or more appropriately a shift in the balance of fear and greed) than a true improvement in conditions. Perhaps the most imminent hazard to financial stability is another flare up in the European Union’s own crisis. Borne from the troubles entailed with burgeoning deficits amongst member economies in an effort to stabilize the economy while still meeting the EU’s strict limits on debt limits, this is a long-term problem by design. Greece, the worst offender, was provided a 110 billion euro bailout by the Union and the IMF. Realizing the issue could spread beyond this one economy, a blanket 750 billion European Financial Stability Facility was approved should any further assistance be needed from another economy. This was a sizable program aimed at forcing confidence. However, those European countries that have been forced to cut spending in order to meet deficit goals will find that the implications for growth and social unrest could find that temporary assistance cannot fix the underlying problem. Should Greece or another EU member decide to restructure its debt obligations or simply defaults, it could undermine the entire European system and send investors reeling for a verifiable safe haven. Short of this critical incident, sovereign downgrades, countries finding themselves locked out of the market and threats of splitting up the Union could generate a more measured impact on underlying sentiment.

Though, the European Union’s financial difficulties are the most palpable threat to market-wide sentiment at the start of the second half of the year (as this is a problem that has generated significant response from the markets already in 2010); it is important to realize that there are other concerns that could upset the delicate balance between fear and greed. One of those concerns that had commanded investors’ attention before Europe crowded out the headlines was a possible asset bubble in China. To help fortify the world’s second largest economy during the previous financial crisis, officials boosted stimulus and leveraged lending. During the period of rapid expansion, this balance of debts could be supported. Now, however, government support is being withdrawn and policy is being rapidly tightened in an attempt to control the problem after the fact. Should foreign demand not compensate for an already anemic level of domestic consumption, the imbalance in the economy (further exacerbated for capital markets due to the lack of foreign funds due regulations limiting a liquidity buffer). And, should China falter, the repercussions for its Asian neighbors could be severe; while the consequences for the rest of the world will also be substantial. Other issues that could instigate a swell in speculative concerns include: an increased focus and sense of uncertainty surrounding sovereign credit ratings; another economic slump; and an early withdrawal of government stimulus before economies and markets are prepared to shoulder the burden.

The Dollar Anchor

Establishing the market’s attitude on risk appetite is already a difficult task; but it is only one half of the effort to establishing a true bearing on the greenback. To further complicate the matter; we have to determine whether the dollar itself will remain the preeminent safe haven currency. It has maintained this function thus far through the depth of its markets, the protection afforded to investors, its role as the world’s reserve currency, and the establishment of risk programs and financial products on the basis of US Treasuries as an essential portfolio component or risk free benchmark. We will cover some of these concerns in more depth and from a different vantage point; but in the foreseeable future, none of these aspects are expected to change.

Looking for an alternative safe haven dollar reveals the trouble inherent in attempting to commit all of one’s capital to another market should global conditions deteriorate. Not long ago, the euro would have been considered a viable alternative to the greenback when looking for a sound region to place funds; but the financial troubles inherent the European Union’s monetary and fiscal capacities certainly curb that appeal and make the currency seem just as young as its approximately 10 years would suggest. Looking for a substitute in the relatively stable economies and financial sectors of Canada and Australia may seem a good idea at first blush; but the they are far too small to hold the world’s capital and are especially prone to volatility when their markets are flush. Those that offer up China as a viable option are 10 years too early as the financial markets are limited to foreign investors and transparency is extraordinarily opaque. In the end, the dollar may not represent the ideal option for a foundation for safety; but there is simply no better single option.

Back to the Basics

With the markets having been so extraordinarily sensitive to risk trends over the past few years, the implications of growth and interest rate potential have taken a back seat in a fundamental assessment of the dollar’s – or any currency’s – health. However, this is an aspect of relative currency performance that is quickly gaining ground. For economic activity, those currencies that have jumped to the top of the risk spectrum when sentiment is rising either have a strong economy or the prevailing expectation is that it will outperform going forward. The same standard applies for yields. And, often times, both rates and growth usually develop hand-in-hand.

For the dollar’s part, the currency has stuck to the virtue of its safety; but the inklings of fundamental performance are starting to percolate. Growth is perhaps the most tangible advantage to the US currency. According to the most timely government indicators, the US economy grew 3.0 percent through on an annualized basis through the first quarter of the year. This is a downshift from the six-year high 5.6 percent pace through the final three months of 2009; but this moderation actually helps stabilize the economy’s recovery. A sharp improvement in activity is expected following the worst recession in generations; but the transition beyond the revival is imperative to sustainability. A serious complication to this scenario is the inevitable withdrawal of government stimulus and liquidity going forward (an issue that all major economies will face). Nonetheless, a three-year high in personal consumption and forecasts for 3.1 percent growth through 2010 and 2.6 percent in the following year put the US ahead of many peers. Interest rates are another matter. Inflation is the US has deflated and is expected to hold at or below the central bank’s target for the immediate future. The market was pricing in three to four 25 bps rate hikes through the first four months of the year; but that forecast has dropped significantly as the financial troubles in the EU blossomed. Yet, through the downgrade in rate forecasts, the forecast for the Fed has maintained a premium to its ECB, BoE, SNB and now even its RBA counterparts (after officials came to the end of their hawkish regime).

On Sovereign Soil

As discussed above, one of the dollar’s greatest fundamental pillars is the strength of the government debt that backs it. Through the history of the United States as an industrial power and then its status as the largest economy, the nation has never lost its top credit rating. Yet, in the past few quarters, this is a possibility that has been discussed more and more. Doubt is born from the nation’s record fiscal deficits and the trouble that entails. Through the 2007-2008 crisis and beyond, the US government created massive stimulus programs to help prevent a recession from turning into a depression. Having turned the corner of the economic slump; it is fair to say this effort has found some success. Yet, now we have come to the point where the market is paying for deferring its obligations. Ratings agencies have warned the world’s largest economy that its top score could be lowered should its finances not be reined in; and this same warning was issued to other major global participants as well. However, what truly is the risk of a downgrade? A downgrade would necessarily indicate a greater chance of default on all or part of the US’s government’s obligations. While greater liabilities certainly increases the chances of this happening; the United States has a unique position in the global financial markets whereby it enjoys a greater flexibility in the acceptable deficit levels its peers will tolerate when purchasing Treasuries. As the world’s reserve currency, a standard portfolio component and the largest net consumer; the United States is in a unique position to continually fund its shortfall despite an increasingly unbalanced book. At the same time, the US government is already starting to make the effort to balance the budget by withdrawing stimulus, selling toxic assets and demanding payment for TARP funds among other efforts. This is a relatively small step; but it is nonetheless a step in the right direction.

A Viable Alternative

Six months ago, when risk appetite was still at the tail end of an astounding recovery from the first quarter 2009 lows, investors and officials the world over were seriously discussing the feasibility of finding an alternative benchmark and reserve currency to the US dollar. With the downturn in risk appetite, this immediate effort has been squashed; but when speculative trends level off, the debate will almost certainly return to life. A long-term impediment to finding a simple substitute for the greenback has come from the euro’s own financial troubles. At the height of last year’s speculative high, the shared currency was seen as an ideal alternative to the dollar due to the size of its economy and the distribution of risk across a number of economies. After months of trouble with member nation’s flirting with default and skirting rules on allowable deficit ratios, we see the true complications of the European Monetary Union. Should a single member of this group default, it would not dramatically hurt that particular economy; but the blatant disregard for EU rules would undermine the stability of the group. This risk is all too real. And, even if the region recovers without further incidence; the cracks in the foundation will not be forgotten. What about other alternatives? If the euro cannot take the place of the dollar on a one-for-one basis; there are no other alternatives that can boast size and stability. Composites and baskets have been discussed; but that becomes exceedingly complicated with debate on how best to rebalance. At best, this is an effort that is years away; but speculation can potential begin much sooner.

The Technical Outlook

USD Index Weekly

USD Index Daily

6 months ago, the 3 wave setback (A-B-C…see weekly chart) from 92.25 indicated that a USD rally, and most likely and impulse (5 waves), was due. That was an easy forecast. Now that the USD has rallied in 5 waves, there is little doubt that the USD trend over the next several years is higher. The question now is ‘how far will the USD correct before resuming its uptrend?’ The wave principle defines no rules with respect to time but since the larger rally is up, it is reasonable to expect that the correction takes less time than the preceding impulse. The USD rally consumed about 8 months so it is possible that the USD will not have deviated much from current price in 6 months. We can estimate levels to expect support however, which is useful for trading purposes. The first level, defined by the former 4th wave extreme, has already been reached. That level is 85.80. The next zone is defined by former congestion (which also happens to be the 50%-61.8% retracements) from 80.20 to 83.00.

If the June high of 89.20 is exceeded, then focus would shift to the 2008 high at 92.25 then Fibonacci extensions at 103.90 and 110.70. Until a break higher, additional corrective action is possible down to the mentioned support zone. In summary, the larger trend is up and dips should be bought but it is impossible to ascertain whether or not the USD will be significantly higher or relatively unchanged in 6 months. Market structure at a certain point in time determines the specificity of a forecast. At this time, market structure requires that we paint with a broad brush.