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US Dollar Volatility and Direction in US Government’s Hands

US Dollar Volatility and Direction in US Government’s Hands

John Kicklighter, Chief Strategist
US_Dollar_Volatility_and_Direction_in_US_Governments_Hands_body_112233.png, US Dollar Volatility and Direction in US Government’s Hands

US Dollar Volatility and Direction in US Government’s Hands

Fundamental Forecast for US Dollar: Neutral

  • The ongoing US Government shutdown is an open-ended volatility risk for the dollar
  • A revival in risk is the greenback’s best chance for a lasting rally, but that would be a complicated theme
  • Trade the US Dollar’s medium-term trend through risk, shutdown and Taper fears with the Dollar Currency Basket

Through Friday’s close, the dollar has dropped for five consecutive weeks (the longest slide in three years) and probed a five-month low. And, that represents only a modest correction to yield and stimulus expectations – not the full scale of risk implications still ahead. There are a number of moving parts for the dollar’s fundamental outlook but it all comes back to one overriding theme: risk trends. Whether we refer to the budget standoff in Washington, the timing of the Fed’s Taper, the durability in excessive levels of leverage or outlook for growth and yields – the common element is the same. We inevitably come back to the balance between risk and reward.

The most immediate concern for dollar traders moving forward – as it is for market participants in most asset classes – is the ongoing budget stalemate in Washington. Whether progress is made or not, there will be an impact on the markets. If we are to continue on with the status quo (the Senate and House refusing to budge on key items like the Affordable Care Act), we will see confidence in the greenback and capital markets deteriorate at an accelerated pace. The impact on US growth is not as concerning as the fear that builds with each day we progress towards October 17 without a resolution. That is the date that Treasury Secretary Jack Lew has said the coffers will run dry and the US will have to bilk on its debt obligations.

Over the past week, investors’ concern was beginning to show through. The dollar extended its bear trend from the July peak and the S&P 500 dropped for a second week to test the floor of its 2013 rising channel. The next stage of a decline would necessitate key technical breaks from both benchmarks which itself would be a reflection of the escalating situation. Progress on this theme will began encouraging deviation from the recently positive correlation between the two however. A stalled deleveraging of the capital market’s position could still leave the currency exposed to rising default risk with capital diverted towards international alternatives. Alternatively, if the budget standoff proves the spark for a more comprehensive unwind (long overdue), the dollar may instead rally as its safe haven profile soars.

It may seem a contradiction that a burgeoning financial crisis originating in the US could in turn leverage the greenback’s safe haven appeal – but that exact scenario played out with the financial crisis in 2008. What began with the toppling of the subprime housing sector in the US quickly spread to overstretched global markets. The key to determining whether the dollar is treated as victim or savior through this event is the intensity of risk trends. Should concern escalate to panic, repatriation of US capital invested in foreign assets and the need for liquidity with regulation will guide capital into US markets. Otherwise, we watch as the dollar suffers slowly.

In the alternative scenario – a deal that ends the budget impasse – there will be a measurable of ‘relief’ rally for both the dollar and equities. Here too, the intensity of optimism that arises from this outcome will determine the currency’s reaction. Should this respite reinvigorate the grab for yield that has pushed US equities to record highs, any dollar rebound on reduced credit risk will be swamped. Yet, it should be said that climbing out of this hole does not represent a new phase of strength – rather it is an averted disaster. If there is a strong risk-positive move in the wake of an agreement, it is unlikely to last for very long.

As we navigate the ebb and flow in sentiment and risk trend moving forward, we will have a bias with which to interpret scheduled event risk. For example, the Treasury’s planned sale of short-term government debt (the one-month bills on Tuesday in particular) becomes an important measure of the market’s concern over the US fiscal/financial situation. The release of important event risk like the delayed September NFPs will depend on when the federal outfit has funds to reopen. A range of Federal Reserve members’ speeches will be interpreted for how long the eventual Taper will be delayed due to the budget trouble. We will likely even see concern voiced by global officials in the IMF’s annual conference which will offer updated growth forecasts. – JK

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