Fundamental Outlook for US Dollar: Bullish

- Where do interest rate and growth expectations fit into the Dollar’s future?
- Risk appetite proves the primary driver of the dollar’s impromptu rally
- Dollar establishes key breakouts across the spectrum

While an objective look at the week-over-week changes for the US dollar-based majors may not point to a potentially market-defining reversal this past week; a look at charts clues us into the magnitude of recent price action. The US dollar forged ahead to five months highs against the euro, a month high against its Canadian counterpart and multi-week highs against both the Australian and New Zealand dollar. On the other hand, USDJPY would actually end the week in the yen’s favor. How do we explain this seemingly dichotomous outcome? Risk appetite - or more appropriately risk aversion. With China announcing its intentions to cool its economy and markets and US President Obama proposing a limit on the size and risk-taking activity of the nation’s largest banks, the world’s largest governments are taking an active role in slowing speculative positioning. As such, traders are growing antsy that profits on positions established through 2009 could quickly turn into losses. So far, panic has not set in and the tides are being held back. However, with the Dow, commodities, bond yields and many other asset classes establishing a bearish bias; all the ingredients are in place for a significant correction.

Heading into next week, there are plenty of fundamental drivers to keep track of when trading the greenback. Yet, when it comes down to it, risk appetite will win out should sentiment (bullish or bearish) swell. How do we know when risk appetite is a significant factor in price action, we will see a distinct correlation between the major securities. If risk aversion is in control, the Dow will tumble, commodities will fall, bond yields will fall and the US dollar will advance. If optimism is revived, we will see exactly the opposite situation. Now that we know the ‘how,’ we need to define the ‘why.’ What would revive the tug-o-war between risk appetite and risk aversion? The most influential factor at this point are speculators themselves. Should traders decide to unwind some of their exposure ‘just in case,’ it would actually feed momentum. Looking for additional fuel from forces outside the market there are plenty of key economic indicators to keep track of and perhaps exogenous risk that we won’t see until it is already upon us.

Preparing for what we can, the docket holds a heavy round of serious data. The most threatening piece of data on hand is the advanced reading of 4Q GDP due Friday. There are two peculiarities to this report. The first consideration is that considering this is a release for the end of the week, it could actually work to anchor the dollar (as long as risk trends aren’t too violent) as FX traders hold off on making dramatic changes to their portfolio before such a meaningful report. The other point to make is that this indicator can have a straightforward fundamental influence on the dollar (establishing its relative strength against it counterparts) or it play a risk appetite role. As the largest economy in the world, a hearty pace of expansion could bolster the outlook for global activity and balance investors’ fears. There are many other indicators that will weigh in as well (consumer confidence, durable goods orders, existing home sales); but the only other events that can rival or play into the undercurrent of sentiment are the FOMC rate decision and perhaps the expected comments from the Fed’s Kohn about interest rate risk. Speaking of interest rates, we should not forget that the US dollar and Japanese yen are both vying for the unwanted title of primary funding currency. When the US 3-month Libor rate is once against at a premium to its counterpart, the US dollar will not be considered the ideal funding currency for a resurgent carry and it will still be considered a safe haven.

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