Fundamental Forecast for the US Dollar: Bullish

The dollar has put in for a remarkable advance over the first week of the 2011 trading year. In fact, taking a quick survey of performance, the greenback rallied 3.5 percent against the franc, 3.4 percent versus the euro and 2.1 percent when matched up to the Australian currency. Just as remarkable is the fact that these individual performances have marked meaningful reversals and potentially revived dormant trends. In sum, this already looks to be the year of the dollar. However, we should become so enamored so early on. It is important to recognize that trading conditions are still highly unusual. A carry over from the year-end liquidity drain into the final weeks and days of December, we have yet to see a full return of speculative capital to the speculative arena. That is problematic; because burgeoning trends can quickly run dry without a crowd to stagger into meaningful developments. So, the question is: will the dollar’s best weekly performance in five months hold over to the coming week.

To establish whether the currency’s strength will hold up; it is first important to establish where it has originated in the first place. Scanning the data over the past week, there isn’t much to give the sense that fundamentals were particularly robust. Where the ISM service sector survey rose to a four-year high and the manufacturing report hit a seven month high; the economic implications here are firmly offset by the discouragingly tepid recovery in employment and the FOMC’s assessment that the recovery is not solid enough to justify an adjustment from the emergency stimulus program. Where was the greenback’s strength coming from then? A tangible explanation can be traced back to the troubles brewing in some of the United State’s largest financial counterparts. Confidence in the Euro-region markets materially deteriorated, Chinese officials are expected to enact further policy to cool its economy and even Australia’s cracks are starting to show. Considering everything in this market is relative, a weakening of the greenback’s counterparts certainly gives it a leg up. Another factor in this performance is the natural pressure for a speculative rebound. Having been driven towards recent record lows against most of its counterparts (excluding the euro and pound), the dollar was primed for a correction in the absent of larger trends.

Carrying through these factors to the coming week and beyond, a reversal for overextended markets will run out of steam quickly. On the other hand, relative strengthening through troubles in other regions is something that can sustain the dollar for a while – that is if fundamentals abroad truly do deteriorate. Yet, if we want a true, bull trend – one that can produce conviction alongside direction – the greenback will need to source its own strength. Growth factors, money supply, policy actions and other such factors aren’t really the encouraging aspects we would expect for a solid rally. Instead, the most influential and pressing driver remains the return of risk appetite trends as the broader financial markets’ primary catalyst. The lack of correlation between the different carry currencies and risk-sensitive asset classes is clear evidence that we are lacking this principal focus. However, it will return – and likely very soon. The prevailing trend is still the carry optimism from the final quarter of last year; but the emergence of global fundamental risks and overextended standing of the capital market’s benchmarks (like the S&P 500) suggest the bigger risk is for a collapse in optimism. And, such a return to speculative flows would certainly benefit the greenback.

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