Fundamental Outlook for US Dollar: Neutral

- Dollar starts to distance itself from trends in the Dow and Yen as the risk holds loosens
- A rebound in capital markets belies a lack of confidence in global market conditions
- Will the dollar correct before extending its bullish run?

Over the past twelve to eighteen months, the markets have moved more or less in tandem. This is a by-product of investor sentiment standing in as the dominant fundamental driver for the market value. Through 2009, the primary trend was the relief as crises ended and speculative capital would once again find its way into the market and subsequently raise asset prices. However, this rally could not last forever; and we have seen a sharp correction in the levels of the market and sentiment since the beginning of the new year. No doubt, risk trends will steer volatility and trend for some time to come; but those investors that are truly savvy have already begun to monitor the breakdown of this all-encompassing correlation. Already, we have seen the correlation between the benchmark currency and fundamental theme deteriorate this past week. Why is the greenback veering off course and will this break from strong tradition continue?

Through 2009, the US dollar was under constant selling pressure first as investors were diversifying away from Treasuries post-crisis and into economies with better hope for return. As the advance matured, though, the effort to invest in higher yielding assets was increasingly funded by US loans. With market rates in the world’s largest economy at record low levels, there was a growing belief that the dollar was an ideal funding currency in the given market environment. Yet, where the currency perhaps fulfilled such a role through the short-term, an assessment with a more distant perspective suggested the greenback would not maintain a funding status for very long. Given the probability that rates would begin rising sometime in the second half of the year and the appeal of US assets in the international market; the dollar would not offer a stable yield differential and posed a capital appreciation risk. However, it wasn’t until recently that these conditions would start to factor in. This past week, a benchmark event occurred when the US three-month Libor rate crossed above its Japanese equivalent. While this was not the benchmark to immediately propel the single currency to the same carry status as say the Australian dollar, it cease any speculation that the greenback was a better source of funds than the Japanese yen. This is one of the primary reasons why the dollar has remained somewhat stationary over the past month while equities have started to appreciate and the Japanese yen tumbled.

Does this shift mean that the greenback has fully relieved itself of its correlation to risk appetite? No. A strong enough rally in investor optimism would likely spur the dollar to losses as there are still bigger factors (like the long-term effort to diversify away from a dependence on the single currency). More importantly, a tumble capital markets (a rise in risk aversion) would still play to the benchmark’s appeal as a safe haven. Yet, absent clear and all encompassing trends in risk appetite, the dollar could attempt to further define its own future. In the meantime, it will be important to monitor the larger risks to stability. Should the Greek situation suddenly deteriorate or Spain, Portugal or Italy fall find themselves in similar positions; the underlying catalyst could once again take over.

As for scheduled event risk, the economic docket does not carry many major market-movers (though it bears mention that even the most prominent economic release – NFPs – wasn’t able to rouse price action this past week). Retail sales and consumer sentiment will offer a meaningful overview of health for the economy’s largest sector. The trade report will be mixed view as it offers a feeling of American’s spending habits and one of the consistent deficits. The other deficit (fiscal) will also be in the news with the budget statement.

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