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US Dollar Ready to Advance on Taper View or Surge on Fear Swell

US Dollar Ready to Advance on Taper View or Surge on Fear Swell

John Kicklighter, Chief Strategist
US_Dollar_Ready_to_Advance_on_Taper_View_or_Surge_on_Fear_Swell_body_Picture_1.png, US Dollar Ready to Advance on Taper View or Surge on Fear Swell

Fundamental Forecast for US Dollar: Bullish

  • We are heading into the first full week of 2014, and the market will weigh in on Taper implications as well as risk exposure
  • NFPs will be the headline event, but there is plenty of calendar items – including the ECB decision – which will guide the dollar
  • Think the dollar is poised to rise or fall in 2014? Take a diversified position on the USD using our Mirror Trader currency basket

Last month, the Federal Reserve took a very sharp monetary policy turn when it announced the first ‘Taper’ of its open-ended stimulus program. The dollar derived limited benefit from the shift, but the general connection between excessive risk taking and the perceived safety net of stimulus (also termed ‘moral hazard’) seemed unfazed. The lack of a risk unwind may have had more to do with the fading liquidity into the year’s end than true conviction in the market’s resilience. Now, with investors returning for the first full week of 2014, there a strong case for the greenback to fight for a controlled advance via improved rate forecasts and a decent chance for a surge should investors’ complacency thaw.

Heading into the new year, the baseline fundamental theme to watch for the greenback is the implication of the Fed’s Taper shift in a currency market that consistently finds guidance through relative monetary policy (what some consider a stimulus war). Up until mid-2013, the dollar was burdened by the perception that the US central bank was content to maintain a state of constant acceleration for its stimulus program. Beyond the support unlimited stimulus affords risk appetite – a detriment for a safe haven currency – it also lowers a currency’s expected returns. And, for a long time, no one could keep up with the Fed’s pace.

Expectations of an ever-expanding balance sheet though started to waver around June. By September, the market had come to terms with the inevitability of a stimulus cap. And, on December 18, the FOMC took its first step by reducing its monthly purchases of Treasuries and MBS (mortgage-backed securities) by $10 billion. Buying assets at a pace of $75 billion is still exceptional, but expectations are working back from an extreme – leaving plenty of room to recover. Now the question is how quickly the Fed can decelerate its effort such that counterparts like the ECB and BoJ will surpass it. Speculation over the timing of the eventual rate hike will also build with time.

Following the December policy meeting, the market started to adopt the assumption that the Fed would reduce its QE program by $10 billion at each meeting – which would equate to a full stop on QE by December 2014. This past week, a range of remarks from Fed officials seems to support that as the minimum pace. Notably, Richmond Fed President Jeffrey Lacker (not a voter) said data would have to be “much weaker” to slow the Taper effort. On the other extreme, the same official said it was possible that robust growth could even read to a rate hike by late 2014. That is unlikely, but we don’t need to realize the hike to see the dollar benefit. We already see the benchmark 10-year Treasury yield at 3.00 percent. Market rates will draw investment capital well before the Fed Funds rate is increased.

Rate forecasts and speculation will continue to build this week as key events feed probability scales. The top-tier event risk will be Friday’s December NFPs report. The jobless rate hit the central bank’s target for ending stimulus with the last print (7.0 percent), and now the burden is to prevent further breaks on QE. In other words, the dollar will be more readily responsive to data that is ‘positive’ and supports a withdrawal of extraordinary support. Other data points such as the trade balance, ADP employment change, ISM service sector survey and consumer credit report will offer guidance but will fall short of the BLS labor data.

Two other US events to keep tabs on will be the Senate’s confirmation vote for Yellen as the next chairman Monday and a House subcommittee’s hearing on QE’s effects on global financial markets on Thursday. Perhaps more effective for rousing the dollar though can be the outcome of events outside of US boarders. An ECB rate decision and round of UK data can effectively tip the scales of the relative stimulus game from the other side of the fulcrum.

The controlled descent of the Fed’s stimulus program is a steady but restrained source of potential strength for the dollar. To see the dollar truly soar, the greenback would best benefit from a market-wide move to deleverage excessive leverage (risk). Given the corollary between stimulus and investors’ exposure, this is a substantial risk. Should capital markets (I use the S&P 500 as a benchmark) start in on a deep correction, we could see raising US yields alongside a wave of demand for Treasuries for safety. – JK

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