Fundamental Outlook for US Dollar: Bearish

-- Federal Reserve adds another layer to its bailout plan with $540 billion to stabilize money market funds
-- Risk appetite continues to deflate as recession fears and deleveraging stoke fear
-- Bernanke tells Congress in testimony the US economy is in a “serious slowdown”

Risk aversion has dominated all markets; and the demand for liquidity and security has sent panicked investors to the US dollar. However, with the world’s largest economy wading slowly into a recession and interest rate speculation pointing towards the lowest returns from US assets in history, how long can the greenback’s rally last? There are two major considerations for how far the dollar’s rally may go: the general level of risk sentiment and the health of the health of the US economy. Before market participants ever concern themselves with returns and the level of interest rates, fear must be stemmed. Panic has overwhelmed the market such that liquidity and safety of funds are the only concerns for capital allocation. This sense of preservation has evolved with time, starting with bank defaults, going on to a credit crunch and then to massive capital losses through the ensuing market crashes.

However, through this process, the true driver behind the declines eventually came to light: leverage. Investors, banks, lenders and even consumers around the world had steadily leveraged themselves on credit since the markets recovered from the bursting of the Dot Com bubble. In the bull market, banks created derivative products to make returns of 30-plus percent, lenders relaxed their conditions and ran down reserves, and consumers drove up their credit bills to record levels to purchase goods. Now, the house of cards has come crashing down; and everyone is demanding their money back. The problem is that the losses that are being incurred have been multiplied by the leverage and is subsequently overwhelming the initial capital that originally supported the deals and investment. Now with margin calls, defaults and illiquid markets, a long line is forming to unwind positions; and the market must deleverage or face catastrophic defaults. This means that all the world’s governments can do is ease the pain – and not stem the tide. Boosting confidence in counterparties, guaranteeing lending and steadying the natural drop in asset values is all the that officials can do.

And, while the market will not likely see the end of its deleveraging next week, we can still see the dollar reverse should confidence in its safe haven status be shaken. There are two major events scheduled for the week that may sour the greenback’s rally. The first release is the Federal Reserve’s rate decision on October 29th. Economists expect a 25bp cut to 1.25 percent; but the market has already priced in a 100 percent probability of a 50bp cut and even a 25 percent chance that the policy board will take the benchmark rate all the way down to 0.75 percent. The central bankers will need to consider whether such a move would even help (as previous easing hasn’t yielded the intended effects with banks not passing on the savings) and if it will instead just invite more problems when the global economy actually recovers. The other prominent event is the follow day’s advanced reading of 3Q GDP. There is little doubt that the US is already one foot into a recession (we need two quarters of contractions for a technical recession), but the long-term strength of the dollar going forward will depend on how shallow the nation’s recession is and how quickly it recovers relative to its global counterparts.

John Kicklighter a Currency Strategist at FXCM.