Fundamental Forecast for the US Dollar: Bullish

The US dollar saw an impressive rally into Friday’s close, bolstered by an encouraging outlook on US Federal Reserve policy and a flight to safety on worries over Greek debt troubles. US Federal Reserve Chairman Ben Bernanke struck a relatively hawkish tone as he said a third round of Quantitative Easing was quite unlikely; the coming week marks the formal end of the QE2 asset purchase program. The end of QE2 hardly guarantees US Dollar strength but removes significant headwinds, and the Greenback could see fundamental support in weeks and months ahead.

A busy US economic calendar promises further fireworks through upcoming trade, and it will be important to watch how the US dollar reacts to increasingly significant economic data. Markets will pay particular attention to Personal Income and Spending, Conference Board Consumer Confidence, University of Michigan Consumer Confidence, and ISM Manufacturing data. Focus remains on whether the US economy can continue to recover and eventually prompt the Federal Reserve to tighten policy. Watch for the US Dollar to be especially sensitive to large surprises in consumer confidence figures and the employment sub-index of the ISM Manufacturing report.

It is difficult to predict whether the USD will see a boost from the formal end of QE2, and one would suspect that the clearly anticipated conclusion is largely built into the current dollar exchange rate. Yet the end of asset purchases removes a hurdle in the way of a US dollar recovery; the Fed will no longer be growing its balance sheet and aggressively increasing the supply of US dollars. The effects of Quantitative Easing have been far-reaching, and we suspect that the end may be similarly eventful for financial markets.

One potential effect is to make the US dollar once again a safe-haven currency of choice, sparking Greenback rallies on significant turmoil across financial market. Already we’ve seen the USD bounce noticeably against the euro on the real risk of a Greek debt default and broader euro zone instability. Yet the US currency has fallen far behind other traditional safe-havens such as the Swiss Franc and the Japanese Yen. The end of fresh Quantitative Easing is unlikely to be a cure-all for the Dollar’s ills, but it could go a long way in boosting its attractiveness against similarly low-yielding currencies.

If our hypothesis is correct, watch for the US dollar’s correlation to equity markets and broader financial market risk sentiment to strengthen through the near term. The Dow Jones Industrial Average’s continued losses have coincided with rallies in our own Dow Jones FXCM Dollar Index. If stocks continue their recent slide into the final week of QE2, watch for the previously-downtrodden US Dollar to stage a further reversal.

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