Fundamental Forecast for the US Dollar: Bullish

The US dollar backed off against most of its major counterparts last week having rallied decisively over the preceding 10 trading days. This was accompanied by either a pause or an outright reversal of the aggressive selloff across the spectrum of so-called “risky” assets that had transpired parallel to the greenback’s recovery since the beginning of the month. Indeed, equities (as tracked by the MSCI World Stock Index) were broadly flat while a UBS/Bloomberg gauge of global commodity prices was up 1.4 percent at the close of trade on Friday having lost 3.6 and 7.8 percent respectively over the preceding two weeks.

As we have argued previously, the reversal likely owes to little more than a corrective retracement, with the larger bearish theme centered around the unwinding of positions dependent on cheap funding through the Federal Reserve’s quantitative easing program ahead of its June expiry running into short-term bargain hunters.Needless to say, markets don’t move in straight lines and some fits and starts were to be expected as the new risk-averse trend took hold. Given the initial selloff’s focus on the end of QE2, it seems only natural that traders would pare some of their recently-accumulatedUSD exposure ahead of the release of minutes from the FOMC policy meeting where the program’s expiration date was set in stone.

The takeaway from that publication proved arguably a bit more hawkish that expected. Most of the major points mirrored Ben Bernanke’s inaugural quarterly press conference in April: the Fed will allow QE2 to expire in Juneand rate hikes may be undertaken while unemployment remains high if inflation expectations become unhinged. While much of this was already well-known, limiting the report’s market-moving potential,apparent unanimous consent to let the balance sheet slowly dwindle over time and increasingly vocal concerns about the “upside risk to the inflation outlook” all reinforced expectations of rising yields in the second half of the year.

On balance, this paves the way for a return to a Dollar-supportive theme in the week ahead as the end of QE2 draws ever-closer. The Fed’s final bond purchase of 6-8 billion in Treasuries is slated for June 9th, which is a mere three weeks away. This hints at rising urgency to unwinding Dollar-funded bets across the spectrum of assets before borrowing costs creep higher. An upward revision to first-quarter Gross Domestic Product figures, putting the annualized growth rate at 2.2 percent versus the previously reported 1.8 percent result promises to reinforce this trajectory, with signs any signs of strength in the US economy naturally tipping the scales in favor of faster monetary policy normalization in the minds of investors.

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