Fundamental Outlook for US Dollar: Bearish

- Markets calmed by the Treasury’s rescue of Freddie Mac and Fannie Mae
- Will Lehman Brothers be the next Bear Stearns?
- Speculation of a possible Fed rat cut emerges on the eve of the Fed’s September policy meeting

It was a precarious position to end the week. Through Friday’s close, the US dollar lost nearly 350 points from its one-year high against the euro and gave back 500 points to the British pound. Now the market will have to decide, has the greenback’s rally come to an abrupt end or is this just a breather before the buying continues? There are two major fundamental themes that could determine the dollar’s trend: the Federal Open Market Committee’s rate decision and the health of the financial sector.

Looking ahead to this coming week’s calendar, there are few notable economic indicators; but one event is all that is needed to send the dollar roaring in either direction. On Tuesday, the Fed policy group is expected to deliver its rate decision; and there is little chance Governor Bernanke and his fellow board members are going to shift the benchmark from its steady 2.00 percent. In fact, all 87 economists polled by Bloomberg have forecasted no change. The markets agree; but from the crowd we can read shades of gray. Fed Fund futures show a modest 12 percent probability of a 25 basis point rate cut come the 16th. As the end of the year approaches, the odds go up. There is a 23 percent chance of a cut on October 29th and 31 percent probability of one on December 16th. While the majority is still firmly against a revived easing cycle, it is a far departure from the near certainty of at least one quarter-point rate hike forecasted only a few months ago that had initially catalyzed the dollar’s rally. Overlaying economic trends on recent Fed commentary certainly supports the dovish outlook. In the past few weeks and month, consumer employment and spending contracted, the housing recession maintained its bearing, inflation cooled and financial markets fell further off kilter. It is notable that after the December meeting, the Fed Funds start to shift in favor of hikes again; but this may change with the commentary that accompanies the decision. Should the group comment on easing inflation, fading growth prospects and persistent financial market disorder, the speculative curve could certainly degrade.

The other theme that could spark volatility in the dollar is the outcome of the Lehman Brothers’ sale. Speculation has run rampant with prospective buyers coming and going while the government has been promised to then balked at funding a sale. Such conjecture can hold traders’ attention for so long before they need action. If there is a sale over the weekend (which seems to be the trend after Bear Stearns and then Fannie and Freddie), the markets will find relief – though for currencies it will be felt more in carry than in the dollar. On the other hand, should the venerable bank fail to entice a buyer and the government let the institution collapse (highly unlikely), the outcome could be devastating for dollar strength.

Jamie Saettele is a Technical Currency Analyst for FXCM.