Fundamental Outlook for US Dollar: Bullish

- Risk appetite takes the lead on the US dollar’s rally
- Non-farm payrolls has a limited impact on volatility, but the fundamentals are still weak
- Will the dollar’s drive straight through next week or are there correction in store?

Considering the extraordinary rally the dollar was able to muster this past week, and the momentum it has added to the currency’s impressive bull trend; it may seem inappropriate to start speculating on when this drive will stall. However, it is vital to always have a view on the life span of a trend. Otherwise, how would we know when to take profit or otherwise stick it out for the full breadth of a developing move? The primary fundamental drive behind the dollar’s current run is a deep source of momentum. The reversal of risk flows in the financial markets can last for some time and entail substantial shifts in underlying capital. Throughout 2009, investors were looking to reinvest their speculative capital that had been idled by the worst financial crisis in memory. From cash and other ‘risk-free’ assets, investors were looking to first put their money back to work and second to avoid excessively risky markets. This meant a large influx of capital into specific markets. Naturally, a bottleneck of liquidity would form; and asset prices would rise dramatically in response. And, though values were undoubtedly depressed when the market’s first reversed higher in the beginning of the year, they were equally overinflated by the end of the year. What we are experiencing now is a move to find an equilibrium that is supported by the potential for growth and expectations for returns. This brings us to the critical question: how much excessive premium is there left to work down?

It is a complicated task to determine when the markets are fundamentally overbought or oversold – especially in the time frame of just the forthcoming week. There has been a move to deflate risk in the capital markets for approximately three weeks now; and the progress that some benchmarks (like the Dow) have made is very modest compared to the initial buildup. For this reason alone, it is reasonable to assume that a natural retracement can develop for a considerable time. However, for the dollar, the currency has already retraced more than 50 percent of its losses against the euro since its early-December reversal. As long as the risk aversion trend maintains its momentum, the greenback will benefit; but the amplitude of the currency’s move can diminish. A market flow reason for this is that the market may be comfortable in reinvesting in safe havens other than the US dollar and Treasuries. Another factor in this move is that carry positions that were funded using the US dollar (which has the lowest three-month Libor rates among its major peers) are being unwound and capital is being repatriated to the US. In near-term, the bearing on sentiment will depend on the catalysts available and the ease in developing trends. The focus will remain on big-ticket concerns like sovereign debt risk, efforts to curb speculation and the focus on potential points of systemic risk. And, with a relatively light scheduled docket, there may be little standing of the way of such trends.

The dollar’s broader trend will be defined by the general quality and direction of risk appetite; but in the end, this will be developed through the unpredictable nature of group fear and greed rather than any definable economic indicators. Among the few definable drivers that can have a meaningful effect on the sense of risk appetite for the global markets are the first readings of 4Q GDP numbers for the European region and Fed testimony on systemic risks. Other scheduled indicators like the advanced retail sales report, University of Michigan consumer confidence survey and trade balance will likely play a reduced role with short-term volatility.

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