There are times when the fundamental and technical horizons for a currency or asset seem obvious and clear-cut. However, the coming six months is not likely one of those periods for the US dollar. From a fundamental perspective, the most potent themes the benchmark currency has faced over the past months and years have been temporarily sidelined. This has had the expected effect of pushing the dollar into a period of directionless congestion. At the same time, the promise that these major drivers will eventually recover their influence over the market presents a high probability of volatility and significant price swings. Looking ahead into 2011, it is highly likely that these dominant market forces will once again encourage changes in position and thereby guide the dollar to a meaningful trend. That said, a consistent bearing for the greenback would depend on a coherent outcome for these various market concerns. Yet, the timing and influence of these themes have will not likely make for a simple outcome. It is in this nuance that FX traders will find opportunity.
When assessing the major fundamental concerns for the US dollar going forward, we should refer to those same factors that motivated the currency through the past year. However, having seen the dollar surge through the first half of 2010 and almost completely retracing those gains through the final six months of the same year; it is clear that timing and prominence of these different catalysts is perhaps more important than their mere existence. For that reason, we will discuss the influence that risk appetite trends, stimulus, relative growth, the threat of another housing crisis, carry positioning and fiscal problems have in the most likely chronological order of impact.
There is Always the Risk of…
Risk appetite is the basis for every trade in one form or another. And, in the spectrum of assets that provide yield contrasted against those that offer safety, the greenback is firmly in the latter category. That fact has certainly hurt the currency over the second half of the past year as the global economy has steadied and an abundance of stimulus has encouraged speculators to take greater risk. The best barometer for speculative interest is the S&P 500 Index given its accessibility and its proximity to capital injections. Taking guidance from this barometer, the climb in risk taking has been slow and steady since early September. In fact, this advance looks especially peculiar as prominent trends of this magnitude rarely last without a meaningful correction that reflects the normal ebb and flow of expectations. The build in optimism is further called into question when we consider the fundamental aspects behind its existence and progress. While global economic activity has shown signs of improvement and the threat level of another crippling financial crisis has subsided; conditions are still far from the robust levels expected when capital markets are usually booming.
The support for the recent upswing in speculative positioning most likely traces its roots back to temporary factors like: the Federal Reserve’s $600 billion stimulus program (its second) and extraordinarily low interest rates. It is no coincidence that the risk appetite specifically measured in US equities began their advance in September – well in advance of the Fed’s adoption of the stimulus program on November 4th. Speculators started to pick up on the potential exogenous support well before it was inducted. That is an important tendency to highlight; because it means that the market will likely reverse stimulus-based positions well before it is actually unwound. That said, the dollar’s risk appetite bearings will be influenced by much more than just stimulus. The collective outlook for yields and capital returns is sensitive to scheduled event risk, exogenous developments and even a simple rebalancing of expectations. What is certain, when sentiment does fault, we will see the dollar rally aggressively and prominent correlations return.
Subsidizing Capital Returns
Looking more closely at the Federal Reserve’s stimulus program; it is important to understand how it logically impacts the currency to establish when conditions will change once again. As we discussed above, the central bank’s injection of capital into the market’s acts as an implicit back stop for the capital markets and it keeps interest rates artificially low. However, another aspect of this effort is that it represents a direct weight on the dollar itself. To ensure the capital is making it into the system, the Fed works through regular Permanent Open Market Operations (POMO) whereby they by US Treasuries on the open market. This effort naturally increases the number of dollars in circulation and happens to further depress the currency as the capital is then turned to more speculative assets (especially those not denominated in dollars).
As of the last monetary policy meeting, the group voiced its intentions to maintain its $600 billion stimulus program through its full maturity in June. That means there will be a consistent burden held over the dollar’s head given the regular Treasury purchases. That said, there is still a significant chance that the Fed could move up the expiration of the program and not use the full allotment originally traced out. This possibility will keep the market interested in the regular policy meetings the central bank holds. Yet, as the expected expiration of this facility approaches; speculators will preempt the effects of its unwinding. This means that even if the Fed stays the course through June, the burden this presents to the dollar will start to dissipate well before.
Back to the Basics
Given the overwhelming influence of risk appetite trends and stimulus flows; we have seen some of the more fundamental drivers for the dollar retreat into the background. Perhaps the most remarkable of these wayward catalysts is the health of the US economy. When presented with the unknown, there is far more for speculators to work with. Yet, the outlook for economic activity is relatively easy to get a bearing on; and therefore there is general agreement on the forecast. In this accord, the masses see a steady but slow US recovery – held back by joblessness, anemic income growth and depressed housing. An improvement or deterioration from this consensus forecast will be seen coming well in advance. However, this theme’s influence as a fundamental driver could once again be amplified through the first half of the year. It isn’t necessarily a concern about the US itself accelerating or deceleration; rather, the interest will be in comparative performance. With China taking active steps to cool its lending-fueled growth, the UK suffering a surprise contract through the final quarter of 2010 and the Euro-area facing an uneven recovery of its own (where some members are expected to suffer recessions); the US could find its self boosted by its relative performance.
The Rumblings of Another Crisis
Through 2010, the crisis that most global traders were focusing on was the European financial troubles. This is still a prominent concern; but it certainly isn’t the only risk to the stability of the capital markets. In fact, the US may once again face trouble in the health of its own housing market. Most traders will recall that the 2007/2008 global financial crisis was catalyzed by the collapse of an over-leveraged US housing market. Since that period of suffering, we have seen US housing prices plunge, sales drop to multi-decade lows and construction grind to a halt. And, through there has been a period of consolidation recently on this front; this sector is far from healthy. Through the past few years’ ‘cleansing’ there has certainly been a correction to more reasonable valuations in housing; but there are other aspects of this market that have not yet been corrected. Commercial real estate has yet to see a similar level of retrenchment. Another concern is the swell of foreclosures and the subsequent lawsuits that these forced closings are illegal. This litigation will keep bad assets on banks’ balance sheets and threaten their stability. Perhaps the greatest threat though is the perpetuation of toxic derivatives (many based on residential mortgages) that have been temporarily transferred to the government or whose losses are rolled forward. This may not present itself as a prominent feature of the dollar’s fundamental landscape in the coming six months; but it will have to be reconciled eventually.
What Kind of Returns Will I Receive
Finally, going back to the reality that everything in the markets is about the potential for return and risk; we should keep a long-term view on the dollar’s yield. A side effect of the dollar’s role as a safe haven currency its exceptionally low benchmark rate. Though an anemic return is unfavorable; a stable and low rate reduces the chance of significant swings while simultaneously discouraging the distorting influence of speculative flows. This is a favorable slant in periods of uncertainty that would benefit the dollar should risk aversion pick up. However, when the excess premium is exercised in a meaningful unwinding of risky positioning (which will almost certainly happen in the first half of 2011), there will be an eager crowd hungry for returns quickly looking to jump back into ‘cheap’ carry positions. When the taste for yield returns, the dollar will easily find itself in the role of a funding currency – a particularly appealing funding currency given it will be a natural short after a risk-aversion run up. With the return of interest rate hikes still well down the road; the greenback will not be able to enjoy gains on risk aversion or relative economic health for very long.
US Dollar Index (NYBOT)
Prepared by Jamie Saettele
Since the 2008 low, the US Dollar Index has endured rallies and declines of roughly 15% to 27%. Four such swings in less than 3 years speak to the volatile nature of the FX market in that span. Still (at the time of this writing), the index sits about 10% above its all-time low (2008). The contracting nature of the pattern since the 2008 low suggests that a triangle may be underway from the 2009 high, with the current move composing wave d towards 8400-8600. The more bullish interpretation treats the up-down-up-down sequence as a series of 1st and 2nd (or A-B-1-2) waves with wave 3 in its early stages now. The rally from the 2008 low cannot be part of the triangle as that rally is an impulse (5 waves). In any case, both counts are bullish. The most recent swing was the 14.8% decline from the June 2010 high, which found support at the 2008-2009 trendline. As long as that trendline remains intact, a bullish bias is favored. Within 6 months, the US Dollar Index should reach at least 8600. If the 3rd wave interpretation is correct, then the index most likely exceeds the 2009 high within 6 months.