US Dollar Climb Growing Increasingly Speculative On Risk Aversion

Fundamental Outlook for US Dollar: Bullish

- Sovereign debt risk takes over for fundamentals to leverage a dollar rally
- Consumer confidence and spending rise, bolstering the case for a meaningful economic recovery
- EURUSD is on the verge of 6-year lows, will the pair enter the next phase of a bear wave?

Traditionally, when we say the market is risk averse, it means that speculative interests are unwinding or deleveraging. Therefore, the masses have come to expect the US dollar – as the market’s current safe haven – to appreciate with the influx of worried capital. In effect, we would think that the transfer of capital into the US currency and its assets would be the farthest thing from a practice of speculation. However, there is indeed a speculative element to these flight-to-quality flows; and this characteristic becomes all the more apparent when the current accelerates. Sentiment itself is a highly unpredictable but very influential component of the broader market. And, though investor optimism may sometimes seem independent of baseline fundamentals (growth, interest rates, capital flows); it in fact oscillates around the more stable, economic trends. In the end, the two will always converge. This is where we must be cautious. While risk aversion is in high gear now, it could quickly level off or reverse. If that were the case, we would find the fundamental backdrop would bestow only a modest advantage in growth over most of its counterparts and a slim yield forecast premium against the euro and pound. Armed with just these details as support; could the dollar continue to forge new yearly highs?

For this reason, we need to keep a close eye on both the developments in risk appetite trends as well as the relative health of the US dollar itself. On this first point, we are at an inflection point. In the currency market, we have already seen dramatic adjustments to the potential European crisis. EURUSD has already dropped nearly 2,800 pips in the span of six months and now the exchange rate sits on the verge of tipping into territory not plunged in four years. From a speculative perspective, making this leap would be a significant gear change for the masses. That would require another major development. For the EU situation, the situation seems untenable. There are too many signs that commitment to help out neighbors is feeble at best (especially after we have heard rumors that French President Sarkozy had to threaten a withdrawal from the Euro Zone to get German Chancellor Merkel on board for a bailout), social unrest is picking up, deficit cutting will inevitably lead to revisited recessions and the long-term issue that there is no fiscal and tax union to match monetary union. Trouble seem inevitable; but if fears subside while this takes a slow burn, risk aversion would likely similarly stall. Other threats are in the docket as well. China is confronting asset bubbles, the emerging market doesn’t have demand to support its rapid growth, and then there is the bigger issue of global sovereign credit risk. What’s more, we have not seen other speculative markets really retrace much of their 2009 build up. A breakdown in other areas could keep the dollar; but perhaps momentum would transfer to AUDUSD rather than EURUSD.

And, if we approached the fundamental picture like a technical chart, the fundamentals would be akin to the 200-day moving average. If growth and interest rates are strong enough, the dollar will rise naturally. However, we are at the point where growth is shifting from stimulus-led expansion to true consumer-based growth and the 12-month rate forecast stands at a measly 50 bps. These are not statistics that a robust trend can live off of. Yet, the US is still on a slightly more stable footing than its major counterparts; and each meaningful update has the potentially to significantly change the picture. In the coming week, the CPI is perhaps top event risk. While the Fed has said it sees little inflation pressure, this reading has held above target. Stay there long enough; and it will eventually force there hand.

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