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US Dollar Ready to Rally as Stimulus Hopes Fade, Risk Trends Shudder

US Dollar Ready to Rally as Stimulus Hopes Fade, Risk Trends Shudder

John Kicklighter, Chief Strategist
US_Dollar_Ready_to_Rally_as_Stimulus_Hopes_Fade_Risk_Trends_Shudder_body_Picture_5.png, US Dollar Ready to Rally as Stimulus Hopes Fade, Risk Trends Shudder

Fundamental Forecast for US Dollar: Bullish

The Dow Jones FXCM Dollar Index managed a respectable 1.1 percent rally this past week on a combination of disappointing data, euro weakness and a fading stimulus outlook (for the Fed and global central banks). However, this upswing merely erases the losses of the previous week and falls short of confirming the next leg of the gradual climb that began for the benchmark currency back in August. This matches the underlying fundamental landscape for risk trends perfectly. We are transitioning out of a period where disappointing economic and financial developments were conveniently overlooked with the expectation that a major policy body would step in and provide a shot of short-term stimulus. Faith that another quick fix is on the horizon (or that an additional program would even yield the temporary highs of previous hits) is deteriorating rapidly; and the reality of current risk-reward levels will shock with speculative benchmarks at recent highs.

To make the jump from sporadic and temporary rallies to a run with conviction, the market’s need to cater to the dollar’s primary strength: its role as an absolute last resort for safety and liquidity. That has always been a difficult position to support considering policy authorities have had a vested interest in maintaining financial stability and supporting growth (with perhaps a mind to lifting the wealth effect as well). That said, it seems that we are starting to reach the boundaries of what the central banks and other policy makers are capable of. Stimulus disciples had the wind knocked out of them a few weeks back when the Fed refused QE3 expectations and instead offered up a smaller version of the Operation Twist scheme (which supports lower, long-term rates and now short-term speculators).

Stimulus hopes really dried up the past two weeks though. The EU Summit offered hope that the greatest threat to global markets (the Euro Zone financial and debt crisis) had found a vaccination that could – if not cure the problem, then prevents its transmission. Yet, doubt has festered with European solutions after two years of consistent disappointment. With the details of the EU rescue noticeably absent, traders were dubious and then outright cynical when the ECB failed to supplement the gap in implementation for stimulus. Making the situation far more unstable for sentiment (and thereby more appealing for the safe haven dollar) is the reality that we were offered a round of accommodation, and sentiment still suffered. The Fed’s Operation Twist 2, ECB rate cut, PBoC rate cut and BoE increase in bond purchases represent an impressive collective effort. Despite that, we find carry currencies, equities and the patient zero euro remain under pressure.

Through the past month, there were plenty of negative economic and financial developments that could have individually crippled confidence, but the potential that the next policy gathering (Fed, ECB, EU, China, etc) could swoop in with support stayed many hands. Having cleared the ECB rate decision and the wait-and-see influence of the June NFPs, there are few events ahead that can carry the necessary influence to maintain hope. On Monday, the Euro-area Finance Ministers will convene (likely to discuss the agreements of the Summit a week-and-a-half ago), but it is unlikely that the make progress on the critical programs alongside the activation of the ESM.

Without the promise of stimulus to hold onto, traders will have only tangible fundamentals to work with. At the very foundation of the markets, the risk-reward balance is set at a severe skew that dramatically contrasts current capital market levels. A composite of the majors’ 10-year government bond yields (the foundation of return for speculative assets) is just off a record low set at the beginning of June. And, while volatility readings are still relatively low, the outlook for growth, returns and fewer outlets for safety present a breeding ground for panic. Looking for catalysts to offer sparks in this flammable situation, we have Chinese 2Q GDP setting the pace for the major economies next Friday and the start of the 2Q US earnings session. In the fantasy of strong growth for the business sector and thereby large dividends, revenues were augmented by cost cutting and clever accounting. Investors and analysts expect that run to come to a disruptive end very soon. JPMorgan’s report on Friday will be a particularly interesting read given its representation of the banking sector and the intense scrutiny they have been under, but Alcoa will be the first blue chip to report on Monday.- JK

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.