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US Dollar or S&P 500 – One Will Fall From Grace

US Dollar or S&P 500 – One Will Fall From Grace

John Kicklighter, Chief Strategist
US_Dollar_or_SP_500_One_Will_Fall_From_Grace_body_Picture_1.png, US Dollar or S&P 500 – One Will Fall From Grace

US Dollar or S&P 500 – One Will Fall From Grace

Fundamental Forecast for US Dollar: Neutral

Friday closed out the best month for the Dow Jones FXCM Dollar Index (ticker = USDollar) in a year. Yet, we have seen some vulnerability to the benchmark just this past week as traders size the currency up to the persistent appetite for yield and the dubious time frame for the Fed’s eventual curb on its expansive QE3 stimulus program. Like investor sentiment itself, the greenback has some fundamental backing; but speculation on market distortions has played just as much – if not more – a role in the currency’s performance than those factors considered to be ‘normal’. Heading into the new trading week and month, either ‘taper’ expectations that have rallied the dollar or the yield-chase that has leveraged the S&P 500 will tumble.

Stimulus and speculative ambition are intrinsically intertwined. The scramble for return is driven by the stimulus program’s ability to dampen volatility – while speculative angst is leveraged due to the fact that returns are also reduced by the same effort. By most accounts, this is fertile ground for creating an asset bubble – which many believe is already in place. Though it was a few years ago, the pace with which markets can come crashing down from inflated levels is still fresh in most investors’ minds. In the event of a true risk aversion move, blind greed (chasing increasingly tepid yields without appreciation of the risk) will turn to blind fear. The resultant deleveraging will send investors fleeing those assets that are most likely to suffer capital withdrawals because they are either too expensive, do not have enough return to compensate risk or are not deeply liquid (volatility spreads in a shallow pool).

Yet, a wholesale ‘risk aversion’ move is an ideal scenario for the world’s reserve currency. It is the dollar’s version of buying stocks after a market route transitions into a long recovery as back in the first quarter of 2009. It does not occur without provocation and commitment. As such, the probabilities of a market-wide shift on such a persistent bull trend like the one for the S&P 500 should be construed as relatively low – even after the late Friday sell-off. However, the magnitude of such a pivotal change means we should always have a plan in place for its eventuality. The dollar – even after its move to multi-year highs through May – will still find a substantial bid in the event of a capital market tumble. The greater the fear, the better the greenback looks. As the pace picks up on deleveraging risky assets, there is less time to seek out the market / asset that strikes the perfect balance of return and risk. Panic circumvents the slow search for yield and drives capital to the most liquid, safe and stable. That is US dollars, Treasuries and money markets.

In extreme risk aversion, the dollar will gain against all but one of its major counterparts – the Japanese yen. Given the sizable stimulus drive in Japan and the rapid depreciation of the currency, the repatriation and drive for safety could very well see USDJPY drop sharply on the highest level of ‘flight to safety’. Further down the scale, a measured retreat from risk may find the dollar struggling to gain significant ground against certain currencies. Without panic to leverage the need for liquidity, market participants can look around for competitive yields in amongst safe haven across the world (choosing Australian government bonds instead of Treasuries for example).

As it happens, the most likely deciding factor for sentiment isstimulus. It has reduced risk, encouraged speculation and filled the gap that has developed between market price and market value. As such, it is easy to imagine how the market would respond to the belief that it would simply end. Of course, it wouldn’t be a sudden stop – and in all likelihood, a serious market drop would likely encourage additional rescue efforts by the Fed and other central banks. However, speculative appetites have lifted market values to levels that reflect the assumption of indefinite support. Therefore, even the talk of a Fed ‘tapering’ carries the weight of the market.

If the taper is to gain traction amongst the speculative ranks, the resulting risk aversion and tempered inflation expectations would play into a strong dollar. That said, the probability of a reduction to the $85 billion per month program in June is very low after the majority of Fed members put the burden on further signs of improvement in the data. Even September would be a reach at this point. That said, if traders ignore the distant risk to ride the wave a little further, the recent extension to the USDollar’s rally through the first half of May could prove overdone. So, due to stimulus and sentiment – either the dollar or S&P 500 (risk) are in jeopardy. - JK

--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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

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