Dollar Finds Progress with EUR/USD, But Rally in Jeopardy

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Dollar_Finds_Progress_with_EURUSD_But_Rally_in_Jeopardy_body_Picture_5.png, Dollar Finds Progress with EUR/USD, But Rally in Jeopardy

Fundamental Forecast for US Dollar: Neutral

If you were looking for a bullish argument to make for the dollar, this past week seemed to offer up a considerable docket of evidence. However, much of the greenback’s strength comes though indirect and unsubstantiated factors – like the sharp drop from the euro this past week. While the universal weakening of the dollar’s most liquid counterparts is surely a viable source of strength for the benchmark currency, it is unlikely to carry a trend for very long as there are too many pieces that need to fall in place. Instead, the dollar needs something elemental – something that caters to its true value. As always, the dollar needs a genuine swell of risk aversion to feed its rise.

Comparing the underlying current of investor sentiment to the dollar’s performance to this point, we find a discrepancy that will inevitably close. On the one hand, we have the equally-weighted Dow Jones FXCM Dollar Index (ticker = USDollar) which posted its highest close for the week since September 2010. And, the most recently leg of this drive was further driven by EURUSD in particular – both the FX market’s most liquid pair and until recently the most ardent argument against dollar strength. Yet, when we look to the standard bearers for risk appetite, we find an ardent lean away from the safe haven. The S&P 500 (representing stimulus-backed investor positioning) closed at its highest level since October 2007 while the yen crosses (epitomizing the carry appetite amongst the currency crowd) refuse to reverse from their multi-year highs.

There is no lack of evidence that can be brought to defend a market-wide risk aversion theory (slowing global growth, financial tension in Europe, tighter capital constraints in China, etc), but it is all empty fundamental potential unless the market decides those concerns demand recompense. As such, we head into a new week evaluating each of the top, scheduled events for its influence over the systemic health of the financial markets.

For top docket items this coming week, the return of the Eurozone financial crisis is a higher risk than what we have seen over previous months. EU meetings are expected to cover Cyprus’ rescue, Greece’s progress and ESM direct bailout for banks; while fourth quarter GDP figures will paint the picture of recession in the world’s largest collective economy. This could bolster the dollar by either an anti-euro or anti-risk appetite.

The same dual-impact idea can actually hurt the dollar via the bearings of the USDJPY. This particular pair has been responsible for a considerable portion of the dollar’s strength – and much of the move is the responsibility of a weak yen. If risk aversion were to kick in, the flood gates of carry unwind on overbought yen crosses would sink USDJPY – a dollar negative development in a risk aversion move. Yet, this may happen even if risk doesn’t lead the way. Japanese officials have already spent much of their monetary policy ammunition to get to this point; so 4Q GDP data, BoJ policy gathering and G20 meeting – where currency devaluation will be a topic – can feed the turn.

Speaking of devaluation, thecurrency war can prove a spark for risk trends or carry its own, unique element for the FX market. Until recently, the term ‘Currency War’ was only implied as a skeptics view towards stimulus that was arguably targeting economic weakness. However, with Japan’s targeted effort and Venezuela’s outright devaluation of its currency, the pleasantries have been dropped. On that point, we have a serious threat to the dollar. In the EURUSD’s recent drop, the concern is that the ECB’s mention of the high currency temporarily put off the reality that the central bank’s balance sheet is palpably dropping (while the Fed’s grows). That preoccupation could quickly dissipate. And, from the USDJPY’s impressive contribution to the dollar’s run, the market may realize that expectations of a grandiose stimulus effort by the BoJ are still 11 months away. In the meantime, the Fed is buying $85 billion in assets per month. – JK

--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

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