2012 Forecast: US Dollar to Rally in First Half, Only to Fade Again
The US dollar’s performance through the final months of 2011 was remarkably strong. The benchmark currency managed impressive advances against its European counterparts (the euro, British pound and Swiss franc) and held its ground against the high-yield commodity currencies despite an advance in equities and other prominent “risk on” financial assets.
Looking into 2012, there are a number of fundamental uncertainties that could potentially define the trend going forward. Taking a page from history, we know to watch for potentially explosive developments such as the return of a global crisis, further large-scale stimulus programs (from the US and from other countries) and the deterioration of the health of the greenback’s most liquid counterpart: the euro. Additionally, you can’t fully appreciate the dollar’s fundamental health without considering the outlook for the US economy, the antsy hands behind idle capital, the presidential election cycle and the slow but persistent global effort to diversify reserves away from the benchmark currency.
To this end, we expect there to be a sharp rally in early 2012, triggered by these uncertainties. This could begin as soon as late February, but may occur later in March or even April. Once this bout of risk shedding has run its course – which could last as long as six to eight weeks – we expect investors worldwide to once again sell the dollar. This would continue the long-term dollar downtrend with no end in sight.
Demand for Dollar Liquidity: Will 2012 be Another 2008?
When we consider the US dollar’s role in global markets, its long-standing position as the world’s most liquid currency and the Fed’s efforts to fight perceived financial crises shapes a dominant use: the world’s go-to safe haven. There are many relatively safe havens in the global markets (the Japanese yen, the Swiss franc, government bonds in general), but the greenback is in its own league. In essence, the global market wants dollars when there is an extreme sense of fear. When the functioning of the financial system itself is called into question, market participants move into the dollar without question.
Heading into 2012, the storm clouds of financial turmoil were already visible on the horizon. Euro Zone sovereign debt was already morphing into a market-wide crisis that threatened to spill over borders. Just like the US Sub-Prime Housing Crisis of 2008, the European fiscal troubles represent a catalyst – not the full problem. The real issue is a combination of three things: the return to a global slump in economic activity (some members are facing another recession); an unsustainable dependence on stimulus for fresh stock market highs; and a general imbalance of exposure between developed and developing economies (the latter being far riskier).
We are already seeing evidence of fundamental conditions breaking down globally (fading GDP readings, hobbled corporate earnings and opened swap lines for US dollars), but we haven’t had much of the panic that defined the collapse in 2008. There has been some level of pressure-relief to be found in the lack of surprise with this current economic and financial downturn in Europe. More importantly, central banks and governments have worked to keep the virulence of the situation in check by forcing banks to deleverage and providing liquidity when needed. That said, the most effective check for panic is the hope of endless amounts of stimulus should investors start to lose money on risky positions. If that faith is shattered, sentiment will collapse quickly and the dollar will subsequently take off.
The Great and Powerful QE3
Over the past few years, policy officials have unintentionally nurtured ‘moral hazard’ as an unwanted side effect of promoting stability in the financial markets. Moral hazard is a lack of concern about the negative consequences in taking on additional risks when it is assumed that deep-pocketed central banks or governments will offer bailouts to prevent investors and financial institutions from suffering large losses. If investors believe that central banks will always “ride to the rescue” when crisis occurs, they will build up large risky positions. If there are lots of large risky positions, central banks are then more likely to mount a rescue and the cycle builds on itself.
We have seen many monetary stimulus programs across the globe (for example: the EU’s assistance to Greece, China’s capital injections into housing related investment and the Bank of England’s bond purchasing program), but no effort has had the same level of impact on sentiment as the famed Quantitative Easing (QE) efforts of the Fed. The “QE2” program implemented in November of 2010 truly cemented the link between market-wide risk appetite and stimulus. Now investor hopes have turned towards a possible QE3 program. The loose consensus in a recent survey of banks conducted by Bloomberg is for the Fed to announce another round of support by the second quarter of the year – perhaps even by April.
If there is another round of QE, the dollar will take a brief but serious hit. In such an effort (which would likely target purchases of mortgage-backed securities to help the housing market), there is an unnatural boost in risk taking that drives traders away from low-return safe havens like the greenback. Additionally, QE naturally increases the supply of dollars in the system. That said, the half-life (period of influence) for such an effort would likely be much shorter than previous endeavors as high expectations are already heavily priced in to markets. The far greater risk would be the realization that such relief wasn’t in the cards. That would leave tremendous value to be unwound from high-risk markets, likely boosting the dollar.
Dollar: The Anti-Euro
Considering that the current winds of crisis originate from the Euro Zone, it is easy to draw the connections between the performance of the euro and the dollar. However, the greenback’s link to the euro runs deeper than the fever of panic. As the two most liquid currencies in the world, there is naturally a tremendous amount of capital that will not move out of the US and European markets even though there are other options.
Such a link holds even greater weight should the ongoing Euro-area troubles start to seriously undermine faith in the permanence of the European currency itself. The currency has only been around officially since 1999, so it is not difficult to imagine the serious problems that it has faced since the original Greek bailout could swell to the point that at least one Euro Zone member abandons the collective. In reality, it is highly unlikely that the currency would be abandoned completely, but fear can always trump rational thinking. People moving assets out of the euro in order to avoid the crisis are likely to continue to choose the liquid safe haven of the US Dollar, increasing demand for the greenback.
When we tap into the elemental concerns behind the dollar, we often find ourselves off the academic path. Nonetheless, there is certainly influence to be found in the traditional GDP readings. If the Euro Zone slips into recession in 2012 (as was projected by the IMF and warned by various policymakers), there are few alternatives for investors to tap for similar market depth. Through the fourth quarter of 2011, the US grew an annualized 2.8 percent. Furthermore, the Fed expects moderate expansion through the immediate future. Should Asia and collective emerging markets also see some slowdown in 2012, as many economists expect, it will funnel capital towards the world’s largest economy.
An Election Year
There is a well-known connection between the Presidential election cycle and the performance of equities, but the link has not often extended to the FX market. That is because, normally, the impact would be incidental. This cycle happens to occur in the midst of a possible return to global economic malaise and financial freeze. Such conditions may require an accommodative and flexible government to provide support. Though, with contention between the Democrats and Republicans building as the months wear on, the threat of legislative breakdown will be exceptionally high. If that is the case, it would certainly represent trouble for the US economy, its budget and trade status. Counter-intuitively, it is more than likely that such headwinds would actually be positive for the greenback, as market-wide financial risk tends to drive investors to the top safe haven.
Roman Solidus, Florentine Florin, British Pound, US Dollar
Though it was a more prominent consideration when the market had the leisure to brush off global risk and look for the highest rate of return, there will always be a push to diversify away from the US dollar. There are prominent economic players around the world (China and Russia amongst others) that believe the 2008 financial crisis was spread specifically because the prolific use of the US dollar across the globe spread the sub-prime crisis. Whether that is a reasonable connection or not, the authorities will nevertheless make the effort to move away from using the greenback as their primary reserve currencies. Whether an effort to diminish the United States’ currency from its position of power or just a means to diversify risk, the dollar is likely to continue to lose its global dominance over time – just like the Roman solidus, Florentine florin and British pound before it. This gradual long-term trend has been playing out for years, and is likely to slowly sap the strength of the dollar for years to come.
The Return of Idle Capital
It may be difficult to imagine with all the current global risks; but eventually, we will come to a point where capital markets are considered to be fairly- or under-valued. More than likely, that will occur after a significant unwinding of speculative positions. With so much investable capital on the sidelines and relatively ‘cheap’ investments to be found in stocks, speculative commodities, high-yield bonds and the carry trade; the dollar will no longer be valued for its liquidity. Instead, it will be disdained for its low interest rates. Timing is particularly important here, but the sooner the risk shake-out occurs, the less time it will take for the shift away from the safe haven dollar.
- John Kicklighter, Senior Currency Strategist
The Technical Outlook
The Dow Jones FXCM Dollar Index (Ticker: USDOLLAR) declined 2.18% in January to slip below the December 2011 low. The current level (roughly 9700) is defined by potential channel resistance, the 61.8% retracement of the rally from the October low, and the November low. The confluence of levels highlights the importance of 9700 to bulls. In other words, a failure to hold at 9700 would shift focus to the 2011 (and all time) low at 9322. It is telling that 12 month rate of change is just -2.43% and 36 month rate of change is actually a positive 2.20% (these are as of the January 2012 close). These figures speak to the range that the USDOLLAR has endured since the 2008 low. It is impossible to know whether the range represents consolidation before continuation of the long term downtrend or accumulation before an incredible bullish reversal from a multiyear double bottom. Subjectively, I favor the latter (bullish) scenario due to the TIME magazine USD bearish cover in August 2011. This cover, showing a US dollar bill with a black eye on George Washington could be seen as a signal of extreme bearish sentiment from which a long term uptrend could begin. Overcoming former support at 9850 would be an early indication that the trend is up towards the October 2011 high of 10089.
Prepared by Jamie Saettele, CMT
- Jamie Saettele, CMT, Senior Technical Strategist
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