Fundamental Outlook for US Dollar: Bullish

- Dollar stands on the edge of another plunge as risk eyes new heights
- Rumors of a replacement for the dollar in oil deals furthers long-term fundamental concerns
- Is the market prepared to hold EURUSD’s double top?

Few would argue at this point that the dollar’s bearings are being dictated by investor sentiment. The conspicuous test of a 14-month low in the Dollar Index last week and the simultaneous push to a one-year high from the benchmark Dow Jones Industrial Average is certainly not a coincidence. Yet, with this relationship in mind, how do we reconcile the side-by-side rallies from both equities and the greenback on Friday? Risk appetite was certainly on the rise - as can be confirmed through the pace of equities, Treasury yields and the yen crosses. The seemingly inconsistent piece to this puzzle is the US dollar. Is the currency decoupling from the financial market’s most influential fundamental driver or is this a fluke that will be quickly resolved? Perhaps just as important of a question: will bulls be able capitalize on the proximity of new highs in optimism and jump start the next leg of a very fruitful trend?

It is a rather straightforward deliberation in speculating the direction of risk appetite. Either it will rise or fall. However, when you throw the dollar into the mix, the outlook is more complicated. We need to first establish the relationship between the underlying trend and the beaten currency. There are essentially two chief concerns that bind the dollar to the market’s will: an exceptionally low market rate and the threat of losing its reserve status. Under normal circumstances, the former is the more pressing issue; but it may have been the dollar’s prominence on the world stage that was likely responsible for Friday’s divergence. Earlier in the week, rumors circulated that oil-producing nations in the Middle East were in active discussions with Japan, Russia and others aimed at phasing the US dollar out as the primary payment for oil deals. This story was subsequently squashed by all groups that were supposedly involved. The merits of this report are questionable; but it is nonetheless a good probability that such a deliberation would come up later if it isn’t already being made. The real interest is in the time frame that was drawn up from this report – 2018 for the change in pricing. This is a considerable ways off and concern over diversification (for oil deals or reserves) is a matter for long-term fundamentals and not short-term risk appetite. The underlying trend in sentiment itself is born largely from capital appreciation which won’t likely sustain itself for much longer. When the market comes to this conclusion, the greenback will likely respond to very different catalysts.

In the meantime, there is always the backup tether between sentiment and the dollar in the form of yield. When the topic of the carry trade comes up, the benchmark interest rates are usually used for comparison; but investors don’t really deal at the Fed Funds rate. In reality, the foundation for a country’s yield is its three-month Libor. This US market rate hit a record low (0.2825 percent) just two weeks ago and has since stabilized. At its current level, the US Libor is at a discount to all of its liquid counterparts; meaning, those looking to establish carry positions are borrowing from the world’s largest economy (which is flush with cash) and investing in other nations at a higher rate. However, whereas the current yield may make the dollar a good funding currency; the medium-term outlook does not. The US is recovering and the Fed is already laying plans to rein in its stimulus. Reductions in some lending programs and testing the waters with reverse repos in the money market fund. So, while a rate hike may be a ways off, a boost in market yields is not.

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