Fundamental Forecast for the US Dollar: Neutral

When all else is equal, the US dollar will fall. This is a direct fundamental link to current risk appetite trends where balanced markets encourage investors to seek out assets with higher return. With that in mind, the greenback is plagued by its exceptionally loose monetary policy which keeps it on the short side of most positive-risk positions. Just how weak is the dollar’s position in the yield spectrum? The yield on the two-year Treasury note yield has dropped for seven consecutive weeks to its lowest level since December (now at 0.476 percent) while the benchmark one-week US Libor rate has accelerated its descent to reach a record low 0.163 percent. For comparison, Australia’s relative rates are 4.84 and 4.78 percent; the Euro-area is floating 1.563 and 1.07 percent rates; and the UK is at 0.92 and 0.59 percent. The dollar can simply not compete when the market is looking for return.

There are really only two scenarios in which the greenback can stage a meaningful recovery. The most immediate and also fleeting dollar booster is a shift in risk appetite trends. Many are familiar with the concept of capital flow as sentiment shifts from high yield to safe haven; but the greenback is not exactly a catch-all for safety. Instead the US is the source for a significant amount of capital used to leverage investments in other counties. This is similar to the yen’s position in the carry trade; but where the Japanese currency boasts a long-term hold on exceptionally low rates, the dollar is a temporary source of cheap borrowing thanks to the Fed’s effort to pump excessive amounts of stimulus into the system. Yet, when leverage works against the market, it is the first thing to be reduced. As such, we keep a very close eye on capital market losses. The S&P 500 is a favored sentiment gauge as this index embodies the additional influence of stimulus.

Though it would take more time to gain traction, the eventual rebound in rates for the US will have a greater influence in lifting the dollar. However, the timing for the Fed to start withdrawing capital and the markets effort to preempt the move are difficult to discern. We know that the capital markets surged well in advance of the actual November 11th start of the QE2 program; so it stands to reason that the market will unwind before that stimulus is withdrawn. That said, the program is expected to hit its objective sometime near the end of June. And though it is unlikely that the policy group will immediately withdrawal stimulus, the market will certainly start speculating on the effects the eventual move will have.

In the meantime, we will keep a close eye on those definable events that can make progress on these larger themes or otherwise jump start short-term bouts of volatility. In the week ahead, we have the top calendar event for the investing world: the US NFPs report. Expectations for this indicator’s influence should be tamed however as there has been little lasting impact from recent releases. If the market is already moving before the release, however, this release can be a useful amplifier. At the start of the week, the US Memorial Day holiday will act to dampen meaningful moves.

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