Fundamental Forecast for the US Dollar: Bearish

The Dow Jones Industrial Average fell 4.2 percent and the Dow Jones FXCM Dollar Index shed 1.2 percent on a tense week for financial markets as the August 2 US Debt ceiling deadline looms large. Traders continue to show real fear that the US Congress and President could fail to pass an extension of the debt ceiling before the country runs short of funds and becomes insolvent. Volatility is virtually guaranteed on a contentious week of trading given US Debt Ceiling threats and an end-of-week US Nonfarm Payrolls report.

US Treasury yields have fallen sharply (prices higher) despite clear risks of legislative inaction, and a great deal of uncertainty remains ahead of the vaunted August 2 deadline. Yet a surge in the shortest-dated Treasury Bill yields suggests that some are pricing in a very small risk that the US may actually default, and it seems like markets may be gearing up for the worst.

At time of writing the House of Representatives had passed the much-talked-about Boehner plan to extend the US Debt Ceiling, but implications for actual progress were unclear as the Senate pledged it would be “Dead on arrival” and not pass a vote. In theory, Senate Democrats could amend the Boehner bill and subsequently vote it through—sending it back to the Republican-dominated House. Yet there are no guarantees that this could actually happen and many factors remain unresolved ahead of the key deadline.

If we fail to see an agreement before the 2nd, it is admittedly unclear how markets could react. In our earlier article on how to trade the debt ceiling, we argued that US Treasuries would fall sharply. Yet the S&P 500 and stocks have been the biggest movers on the debt ceiling impasse and traders have actually been buying US Government debt on a flight to safety. That really begs the question: is there a true alternative to the Treasury bond as a safe-haven asset, even in the face of US default?

What happens next is frankly anyone’s guess, and how financial markets respond is quite clearly another guess. As it stands equities continue trading lower alongside the US Dollar, and momentum would favor further declines in both. A breakthrough on the debt ceiling could in theory reverse recent losses, but this author believes that the Greenback could actually decline on sharp S&P 500 rallies. It will be important to watch what happens next with debt ceiling negotiations, and obviously we anxiously await Sunday’s open to see how markets react to fresh developments.

Once markets get past the uncertainty surrounding the debt ceiling, US economic data will again come to the forefront with a key US Nonfarm Payrolls report due Friday, August 5. Sharply disappointing June NFPs data quickly sunk the US Dollar against all major counterparts—especially the Japanese Yen—as traders priced in low US interest rates for the foreseeable future. Any similar disappointments for July data could legitimately push the balance in favor of fresh monetary policy accommodation and Quantitative Easing Part 3 (QE3). Given sharply disappointing Gross Domestic Product results, it could be only a matter of time before traders price in QE3 and sink the US Dollar accordingly.

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