Fundamental Outlook for US Dollar: Neutral

- An absence of fundamental options increases the dollar’s dependency on sentiment swings
- Consumer confidence marks its sharpest decline in nearly two years as spending forecasts dim
- The dollar’s end-of-week strength fights remarkable momentum and pull of two-month lows

The dollar's path is growing more difficult to interpret. Not long ago, the currency would respond immediately to notable shifts in underlying investor sentiment all the while playing the role of the favored safe haven. In recent weeks, however, we have seen that the deteriorating fundamental health of the benchmark currency is blurring the reaction to the still active flux in risk appetite. This change can be partly attributed to the fact that confidence has climbed sharply (a move that perhaps contradicts the dominant current for speculative markets); and that the greenback’s primary counterpart and the source of most investors’ concern (the euro) is putting up a remarkable recovery. Putting this weak performance into perspective, the dollar has forged two-month lows and has established the most meaningful correction in its otherwise uninterrupted rally since it began this past December. Looking at the dollar’s recent activity in relation to its performance so far this year; we better see the fundamental question at hand: has the dollar reversed or is it merely putting in for a much-needed correction?

Though we could support either scenario with an extended decline from the single currency over the next few weeks, we are more likely to see a definitive picture of direction over the coming week. The immediate concern in risk appetite. We ended this past week off with a remarkable drop in risk appetite that led to a 2.9 percent tumble from the S&P 500 and established similarly weak performances for many other growth and yield-sensitive asset classes. Many would assign the performance of the session’s economic data for the results; but the move actually occurred before that. In reality, the second quarter earnings data for Bank of America and Citigroup were the culprits for the tumble. Though they would be consensus forecasts, the deterioration in lending and write downs on bad assets are seen for what they are: bad for the entire economy and market. There are further important earnings statements due in the week ahead; and a skeptical crowd will not have to dig far to see trouble in the accounting.

The greenback will almost certainly revert to its function as a safe haven currency should sentiment trends develop enough momentum; but for it to truly regain its footing, we will likely have to see the euro fall out of favor once again. That may not be difficult to accomplish. On Friday, the European Union is scheduled to release the results of its stress test on the region’s largest banks. There is already discussion about how lenient the conditional scenarios are as well as a notable lack of truly troubled banks from the list. Should these facts be focused on rather than artificially optimism results from the tests; the effort could very well backfire on officials, send the euro plummeting and shutting European banks and governments out of the capital market.

In the absence of a clear risk trend and tumble from the euro, the dollar could see its strength continually eroded. When sentiment trends eventually do level off, the greenback will be valued on the same traits that every other currency is judged: relative growth, stability and interest rate potential. The US is hurting for all three; and it is growing increasingly difficult to cover up. The lead up to the 2Q GDP release on the 30th, talk of the nation’s ballooning deficits and the reality of no rate potential for the foreseeable future work against the dollar.

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