Fundamental Outlook for US Dollar: Bearish

- A swell in risk aversion bolsters the dollar’s safe haven status, but for how long?
- Policy officials struggle to get a handle on the recession and ongoing financial crunch
- A record decline in housing starts shows that the catalyst for the global recession continues its plunge

The market will have to make a critical decision on the primary fundamental function of the US dollar within the next few weeks; and the ultimate verdict could finally put the world’s reserve currency back on pace. Bringing the greenback one giant step closer to a definable trend in the week ahead are two key drivers: risk sentiment and economic activity. Should global financial markets seize and credit vanish, the US dollar will fall back on its role as liquidity provider and capital guarantee for international investors trying to preserve their funds. However, without the overwhelming influence of fear, genuine economics could otherwise deflate the currency backed by perhaps the worst economic outlook in the developed world. With the stakes waged, let’s take a closer look at how these factors may play out.

Considering the market-moving potential behind the busy docket for the coming week, it is best to take score of the economic health of the US economy. There are more than a few, first-tier indicators scheduled for release throughout the week that will alter the course of the country’s overall health. Among the notables are the new and existing home sales, durable goods orders and consumer confidence – covering three key sectors of the world’s largest economy. However, where these individual indicators only represent a piece of the whole, the government’s GDP report will set the benchmark for the entire economy. This will be the advanced (or first) reading of activity through the final quarter of 2008. Even from a cautious standpoint, the number is expected to be dismal. The consensus of economists polled by Bloomberg forecasts the recession to accelerate to a startling 5.0 percent on an annualized basis. A slump of this magnitude would surely put the US in the running for the worst performing economy among the industrialized world. Looking more closely at the components of the aggregate report, speculators may further get a better handle on the pace the recession will keep into the first quarter and half of 2009. A drop in construction and business activity is fully anticipated; but as the largest component of growth, consumer spending will determine whether momentum is behind the slump or an end is in sight. What’s more, traders around the world will be watching this report to gauge the health of the global economy. As the largest nation in the world, the US could exacerbate or ease the global pain.

In preparing for this notable and foreseeable piece of event risk, we should also consider that this release will be vying for influence over the dollar with a fundamental driver that is constantly in the background – risk. Since July, the greenback has found significant strength through fear and deleveraging that has diverted capital into US Treasuries and thereby the dollar. Recently, these trends have waned; but necessary rescues of multiple banks, downgrades in debt ratings for entire nations and an accelerated recession are providing traction for the definitive safe have once again. On the other hand, we should not simply assume the dollar will always hold this role in the market. The FOMC is going to hold rates near zero on Wednesday and is unlikely to present any helpful policy to stabilize the economy. What’s more, the US government is flirting with nationalizing the financial sector with recent rescues of institutions like Bank of America and Citi. These policy moves will discourage investors and could ultimately threaten the nation’s solvency.

John Kicklighter a Currency Strategist at FXCM.