Fundamental Outlook for US Dollar: Bearish

- Fed joins other global central banks in delivering a surprise 50bp rate cut
- Credit crisis casts risk aversion shadow across all markets; and the dollar benefits, for now…
- Traders left to tally the damage for the worst week for the markets since the Great Depression

Despite the approval of a massive $700 billion bailout plan and coordinated global rate cut, panic continues to dominate market sentiment. For the US dollar, the influence of this undesirable state will determine whether the currency can sustain its aggressive rally or a dramatic retracement brings it back to Earth. To understand where the greenback will go, we need to first understand how it has come to this point. How can a currency that represents a 1.50 percent benchmark lending rate, an oncoming recession and the epicenter for a financial crisis rally against nearly every one of its major counterparts? Security. While the dollar has few redeeming features fundamentally, the US is still the largest economy in the world with deeply liquid Treasuries that can be unequivocally deemed ‘risk-free’ even as traditional asset classes suffer their worst declines in decades. This safe haven status has proven itself to be nearly as universal as the sell off in risky assets has been. However, the consistency can work both ways. Just as surely as the demand for liquidity has driven the dollar higher, a return in risk appetite or signal that the US market itself is no longer a refuge could quickly reverse the dollar’s fortunes.

Monday happens to be a US banking holiday (Columbus Day); but few Forex traders will likely take the day off. Instead, they will be joining the world’s masses in appraising the plans that come out of this weekend’s G7 meeting. At the close of Friday’s US session, the global economic authorities released a list of agreed upon “common guidelines” for addressing the ballooning crisis. The vague steps called for: taking ‘decisive action’ to support systemically important financial institutions; unfreeze credit markets and secure liquidity and funding to banks; ensure the ability for firms to raise private and public funds to revive confidence; guarantee national deposit insurance; and restarting secondary markets for securitized assets (like mortgages). These are lofty goals and politics will be a high hurdle to make headway on any and all of them. However, details and action are what this skeptical market will need to revive confidence in lending and investment. More than likely, additional monetary easing (cutting benchmark and discount lending rates) and capital injections will be points that can be easily passed. What the market really needs though is all-encompassing guarantees on interbank lending and consumer bank deposits.

Months and years from now, recent record-breaking market declines will be considered panic or irrational exuberance. However, the longer this imbalance lasts, the greater the long-term impact will be on the financial markets and economic growth. Policy and regulation may hamper a return of speculative funds just as surely as lingering fears will. What’s more, the pinch on lending that is being felt now is already guiding the US towards recession. Nevertheless, policy officials have few options other than taking extreme steps to put out the fire.

John Kicklighter a Currency Strategist at FXCM.