Fundamental Outlook for US Dollar: Bullish

- The dollar develops strength through interest rate forecasts, relative growth projections and risk aversion
- Consumer-level inflation revives the argument for hikes but FOMC holds the line
- The dollar keys in on potential breakouts against the Euro, Australian dollar, British pound and Canadian dollar

The dollar rallied against all of the majors this past week. In fact, on a trade weighted basis, the greenback has rallied for nearly three weeks and climbed over five percent trough-to-peak. More importantly, putting this strength into perspective, the advance has tentatively called for a meaningful trend reversal in the reserve currencies favor. This is a long-overdue reversal considering its initial decline developed through most of 2009. However, this rally will carry the qualifier “tentative” until after the abnormal trading conditions of the year-end period pass and the underlying investor sentiment finally collapses under its own weight. We are heading into a highly reactive and malleable period the markets; and nascent trends can be quickly snuffed out or heartily amplified given the right combination of conditions. Which combination should we expect of the greenback?

The most impressionable and vague dynamic for the currency market over the next few weeks is general trading conditions. Most of the Western world will shut down for the Christmas holiday; but liquidity will drop off well before the actual markets close and will remain depressed until after the turn of the year. History has shown us instances where similar situations have stabilized markets and dampened volatility; but there have also been cases when the leveraged influence of speculators has amplified price action and setoff meaningful breakouts. Though we cannot truly tell which level of activity is in store for the markets next week, the abundance of potential energy and a busy economic docket warrants caution. Considering the aggressive move the dollar has made over the past three weeks, the currency is working with considerable momentum. Extending or retracing this move would merely be a factor of speculative interest (which there will be no shortage of through the end of the year).

There are a few prominent drivers that should be monitored. Interest rate speculation has been a major contributor to the dollar’s strength so far; and the consensus forecast for a hike in June is closing in. This also ties directly into the currency’s standing on the risk spectrum. The benchmark US market rate (the three-month Libor) is still edging towards record lows; but its pace has slowed. This factor has certainly contributed to the dollar’s malaise as investors have moved from diversifying safe haven assets to using the currency to fund the reemergent carry trade. However, a long-term assessment of financing tells us that US rates will rise eventually (and more likely soon). And, though the Japanese Libor is trading at a premium now; the government’s fight against deflation means the cost of financing in the Land of the Rising Sun will be far cheaper over the long-term. Finally, the most prolific threat to volatility is underlying risk trends. While the appreciation in a number of asset classes can be attributed to risk appetite; in reality, sentiment has been in a holding pattern for the past few months. A clear break from the Dow (above 10,500 or below 10,250) would likely command a significant reaction from the dollar.

And, while there are major fundamental themes in the background, it is important to remain conscious of scheduled event risk. The economic docket is littered with notable releases that can leverage volatility during the thin liquidity conditions. Top event risk though the period is the personal spending and income data for its updates on consumers – the critical component of growth. Other notables include: new and existing home sales; durable goods; and the Chicago Fed’s National Activity Index. We may be in for a crazy week.

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