Fundamental Forecast for the US Dollar: Neutral

It was already difficult to be a dollar bull – only the most speculative traders and those purely following fundamentals seemed to be left in this quickly dwindling camp. And, with this past week’s extraordinary tumble into the drain of liquidity synonymous with the weekend, a concerted effort was made to flush those hold outs by driving the Dollar Index to its lowest level in 17-months. However, traders that see this as a cue to take a new short on the greenback should step back and reconsider the fundamentals behind this move. A review of those factors that have pushed the currency to its current lows and the balance of risks going forward tells us that the risk of a (bullish) reversal is higher than a perfunctory analysis would suggest.

First, it is important to reverse engineer the fundamentals responsible for the dollar’s performance to this point to understand what is most important to the market. There are a range of secondary concerns that are either too narrow in scope (high unemployment, the threat of a government shutdown) or distant in quality (the greenback’s diminished position as the global reserve currency) to pose an immediate threat to speculative interests. Core to traders’ concerns today is the potential for yield balanced against the risks levied against financial stability – an equilibrium that has clearly shifted in favor of returns. On this front the dollar has fall far behind the curve.

Recently, evidence seems to be building behind that eventual shift in monetary policy. Fed officials like Dallas President Fisher, Philadelphia President Plosser and Minneapolis President Kocherlakota have signaled a growing dispute for ending the extremely lax approach to monetary policy. And, through actions, the Fed has further removed the reins on some TARP banks, tri-party reverse repos are testing the market’s tolerance for a withdrawal of stimulus and the New York branch is starting to sell its Maiden Lane II portfolio’s toxic debt holdings. Yet, for timing, this pegs an actual rate hike from the FOMC in the fourth quarter of this year at the earliest. After the ECB’s decision to hike rates this past Thursday, that may be too long a delay for speculators.

The dollar’s yield disadvantage against the euro (its primary counterpart) is expected to grow quickly with the market pricing in a 60 percent chance of a 50 bps hike from the ECB at next month’s meeting and a 12 month forecast for the Euro-region benchmark to be an additional 100 bps higher than its already considerable advantage by this time next year. The divergence in the euro’s and dollar’s rate forecasts producers a strong and constant pressure (just look at the performance of the Australian dollar against its low-yielding counterparts when the RBA was in the middle of its hawkish regime). However, this drive is not guaranteed; and in fact, it faces considerable risks going forward.

The most immediate risk is that expectations for the ECB changes. Why are we more concerned with the European central bank than the Fed? The US policy authority is likely to sustain its steady approach towards normalization; but high-level speculation behind the ECB has a lot of room to recede should investor confidence slip. Perhaps the upcoming March CPI reading – expected to hit a 2.6 percent annualized clip – can further accelerate the shift. However, the greatest threat to the steady EURUSD trend that has held through the year is risk trends themselves. Should optimism collapse, rate expectations will recede and demand for a safe haven will reverse carry funds.

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