Fundamental Outlook for US Dollar: Bearish

- Dollar-based majors mark major tentative breaks from month-long congestion
- Financial crisis and recession lead consumer debt to drop for the first time in history
- Price gauges near deflation and consumer spending contraction sets record before Fed decision

Has risk sentiment taken a significant turn for the better or is the dollar losing its status as a safe haven currency? This is the fundamental question for dollar traders and even to those participants in other currencies and securities. This past week, month-long congestion patterns behind the major pairs finally broke down. Breakouts were inevitable; but considering the depressed levels of sentiment and the dour outlook for the global economy, the fundamental lean was towards a revival of the bearish trend that has found deleveraging favoring the world’s most liquid currency. So, was this reversal from the dollar represent a significant shift in the risk? Unlikely. The Japanese yen (the other key flight-from-risk currency of choice) actually rallied against its liquid counterparts after the US Congress struck down heavily debated rescue for the ailing auto industry. Next week, the market will have to see whether the Treasury will fulfill the White House’s proposal for a temporary bridge loan until a better solution can be found. However, looking deeper into the issue, figures that have been thrown out will not likely stabilize this teetering industry. What’s more, the car manufacturers are not the only one’s suffering, nor is the US the only nation that is seeing its rescue efforts coming up far short of turning economies and thawing credit.

The other question that the dollar’s reversal raises is whether the currency is losing its safe haven status. Initially, the distinct seizure of the financial markets beginning in October sparked a sense of panic and sent funds on the hunt for safety in the form of liquid, stable and essentially risk-free Treasuries. However, this extreme in sentiment has since clearly tempered - though caution is still holding to historical highs. A sense of stability has allowed investors the luxury of reassessing where their funds would be safest. Demand for treasuries is still at record highs as is seen in the negative yield in short-term T-bills recently. On the other hand, the outlook for growth in the US is particularly ominous and the need for bailouts from large industries compromises the sanctity of the government’s guarantee – not to mention the hope for any level of return on idle capital.

There is a third scenario for the dollar’s future that should be considered as it the most probable. With the majors coming to the end of their highly visible congestion patterns, their was a clear need for resolve. However, reviving the dominant bear trend would present a significant market shift just as liquidity was fading into the year end. The least evocative option was for a dollar reversal that broke with risk trends. At the same time, this could be a temporary divergence that lends itself to a congestion scenario for the market in general through the year’s end. This theory will be put to the test immediately next week with the Fed’s rate decision on Tuesday. Though heavily priced in, a 75 basis points rate cut to 0.25 percent (according to Fed Funds futures) will gauge the market’s sensitivity to the balance of risk/reward that will become more prominent when confidence returns. The other major mover could be any news on US bailout efforts. Should these events trigger a bigger move in the dollar, this could be a volatile holiday period.

Antonio Sousa is a Currency Analyst for FXCM.