Fundamental Forecast for the US Dollar: Neutral

Fundamental conditions have not deteriorated markedly for the dollar over the past few weeks; but sentiment surrounding the currency certainly has. With market participants looking for a consistent trade to take advantage of while broader capital markets seem to struggle for direction, the greenback-funded carry trade has turned into the FX traders go-to position. With this preconceived belief that a dollar-short is a solid setup, the masses are far more sensitive to negative developments and simultaneously downplay positive events. There are a few catalysts due this coming week that can temporarily alter the benchmark currency’s fortunes; but to truly alter its course would require a deeper fundamental shift. We should head into the new trading week expecting prevailing trends to hold up; but also be ready to recognize and react to changes in the backdrop.

As usual, the most immediate threat to the established (bearish) dollar trend is a meaningful change in risk appetite. This is one possible driver that can have a lasting impact on the greenback and it also happens to present a constant threat for speculators. The negative revision to United States’ credit outlook (not an actual downgrade) presents a good example of this drivers influence. Despite this development specifically weakening the United States’ financial health, the greenback actually appreciated immediately after the news was fed over the wires. This unusual development reflects the headlines impact on investor sentiment – briefly leveraging the dollar’s safe haven status before investors recovered their sense of optimism. Though this ‘negative’ outlook technical represents the rating agencies belief that there is a one-in-three chance that the sovereign credit rating will be cut within two years; most market participants recognize that is a very unlikely scenario. Therefore, sentiment is quick to recover; but then again, this is another reason to bemoan the dollar.

The potential catalysts for risk appetite are varied; but few have proven truly worthy of the market’s attention so far. We should keep a weathered-eye on the financial situation in the Euro-area, the excess capital in the emerging markets and the buoyancy of speculative benchmarks; but these are only potential drivers until the masses are forced to respond. A greater opportunity for kinetic energy resides with the scheduled 1Q GDP reading. While pundits and policy makers have maintained cautious assessments of the US economy’s health owing to employment and depressed performance in various sectors; the robust growth readings have been a sticking point for investors. If this indicator reflect a tempering that is greater than the already projected slowing to a 1.9 percent annualized pace (from 3.1 percent in the previous quarter), the dollar’s stock could once again rise while confidence in the US condition generally falls (much like I did with the downgrade to the outlook for the credit rating).

Yet, a drop in GDP and slip in risk appetite will struggle to keep the dollar’s attention. Even if the capital markets unwind, the greenback may not keep pace with the redistribution of capital. To truly put it on a bullish path, we need to change the appeal of the currency itself. The best way to do that is change expectations for its inherent yield. More important than the GDP report this week is the FOMC rate decision. There is almost no chance of a chance to the benchmark rate or the quantitative easing program; but this meeting is different than those of the past few years in that Fed Chairman Ben Bernanke will start his post-decision, quarterly press conferences. Is it a coincidence that this effort corresponds to the end of the QE2 program in June? Unlikely.

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