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US Dollar: Is This the Long-Awaited Recovery or a Temporary Bounce?

US Dollar: Is This the Long-Awaited Recovery or a Temporary Bounce?

2011-05-06 23:54:00
John Kicklighter, Chief Currency Strategist
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US_Dollar_Is_This_the_Long_Awaited_Recovery_or_a_Temporary_Bounce_body_Picture_4.png, US Dollar: Is This the Long-Awaited Recovery or a Temporary Bounce?

US Dollar: Is This the Long-Awaited Recovery or a Temporary Bounce?

Fundamental Forecast for the US Dollar: Bullish

There was plenty of data and US-based event risk this past week to suggest to the casual observer that the dollar was running on its own fundamental strength; but experienced fundamental traders should notice something was amiss. Though there were particularly hawkish comments from voting Fed member Kocherlakota, a better-than-expected non-farm payrolls report and a strong manufacturing activity survey; these developments don’t tap into the larger fundamental drivers behind the greenback. Typically, the catalysts that can lead to meaningful dollar (bull) trends are: broad risk appetite; interest rate speculation and relative growth (return) potential. Yet, all three of these have offered only modest support to the greenback recently. Fueling a dollar rally in their absence though is an unfamiliar motivator – aggressive euro selling. Will this indirect strength keep the dollar buoyant? Will one of the usual themes step in to keep the currency’s momentum? Regardless of what takes up the dollar’s call; the market seems to be far more aware its positive features.

Separating the fundamental factors behind the dollar’s performance is key to establishing where it will head going forward. First, it helps us determine what we should be keeping an eye on; but more importantly, it helps gauge the permanence of the support. There was certainly a few developments that played to the underlying strength of the dollar this past week; but they weren’t of the caliber that could drive the Dollar Index to its biggest weekly rally since the opening move of the year. Over the past year, one of the greatest burdens for the greenback has been its relationship to the euro. The FX market’s second most liquid currency has shown the same regional growth and financial uncertainties as the dollar; but it has fully exploited its growing yield advantage. This connection works both ways though, so the market pulling back on over-leveraged rate ECB expectations and rumors that Greece will quit the euro benefits the greenback.

Looking ahead, the euro connection can certainly maintain its support of the US currency. In fact, momentum from EURUSD would offer the best potential for meaningful dollar gains. To undermine the dollar’s primary antagonist, the most dramatic impact would come through Greek rumors finding traction with some measure official confirmation. European policy makers will do as much as possible to prevent this from happening; but even should this particular concern be answered, the masses are already paying close attention to the euro’s troubles. The pullback in ECB interest rate expectations, talks of an ‘adjustment program’ for Greece and other EU peripheral member economy issues can easily take over for worried investors and FX traders.

Looking back within the dollar’s own fundamental borders, we will keep the focus on those top three concerns. Relative growth holds the least potential; but Fed interest rate expectations can be stoked by a dense round of central banker commentary and (more importantly) the April CPI numbers due on Friday. The ECB seems to be on the path of preempting second round inflation effects; so perhaps a 3.1 percent annual pace of price growth will encourage its US counterpart to consider the same. The most influential catalyst is likely to be the direction of risk appetite and its influence on the dollar’s safe haven status. The S&P 500, oil and high-yielding currencies have all dropped significantly this week. We should hesitate to label this a true reversal in sentiment; but it’s close. – JK

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