Fundamental Forecast for the US Dollar: Bearish

It was a tough week for the world’s foremost currency as it finished sharply lower against key counterparts on sovereign credit rating fears and lackluster interest rate prospects. Traders began pricing in the previously unthinkable—a US Treasury default—on risks that US legislators may not agree to a budget deal as the government will soon run short of cash. Fed Chairman Ben Bernanke likewise sounded sunk the Greenback as he struck a dovish note on the future of monetary policy, and indeed risks remain weighed to the downside in the week ahead.

An effectively empty economic calendar means that focus will remain on ongoing debt negotiations and implications for the probability of a deal on the debt ceiling. Top ratings agencies Moody’s and Standard & Poor’s rocked bond markets as they downgraded outlook for the US sovereign credit rating. Traders have suddenly questioned the US Treasury bond’s traditional role as the world’s risk-free asset as politicians remain retrenched in tense budget negotiations.

The issue at hand is quite simple: will the US Congress and President raise the Federally mandated limit on US Treasury debt ahead of the August 2 solvency deadline? Government officials have raised the debt ceiling 11 times in the past 10 years with relatively little fanfare. Yet pre-election year politics and an increasingly emboldened Republican party raise the prospect that the Treasury could default on key payments.

As our debt ceiling trading guide emphasizes, the implications for the Greenback are more nuanced than one might assume. The US Dollar could quite likely see sharp declines on a Treasury default. Yet the biggest reaction may come in the currencies with the highest short-term yields against the lowest (i.e. the forex carry trade). Such a dynamic puts the US Dollar in an admittedly unclear position. On the one hand, the Greenback would tumble on decreased confidence in its government debt. On the other, it could strengthen on sell-offs in financial markets on Treasury bond-linked turmoil.

The debt ceiling is clearly grabbing the major US headlines at the moment, but the biggest long-term driver of US Dollar volatility will likely come on inflation and employment data going forward. Fed Chairman Bernanke sent the USD reeling as he struck a fairly dovish note on monetary policy and detailed the steps the Fed could take to loosen monetary policy further. Markets reacted strongly, predicting that the Fed would leave interest rates at record-lows through the coming 12 months.

Yet the Fed’s next steps will almost certainly depend on economic data, and markets will prove especially sensitive to surprises. A relatively empty week of event risk promises little in the way of fireworks. Yet it will be critical to monitor data going forward, and we may be entering an extended period of pronounced US Dollar volatility on clear doubts over the US Treasury and central bank.

DailyFX provides forex news on the economic reports and political events that influence the forex market.