Fundamental Forecast for the US Dollar: Neutral

We had a tremendous intraweek rally from the US dollar this past week; but ultimately, the currency would finish the week with little progress towards a long-awaited bull trend revival. Nevertheless, the increase in volatility and renewed appreciation for the greenback’s specific brand of safe haven appeal leverages the possibility for a bigger market shift developing going forward. Assessing the timing for a significant market trend developing behind the dollar and/or broader capital markets is a practice in recognizing when the underlying fundamental drivers are changing. In the coming days and weeks, two particular concerns stand out as major catalysts: the Euro-area sovereign funding crisis and the impending end of the US QE2 program.

The deteriorating situation for Greece is perhaps one of the most pressing and ominous concerns for the markets. On the face of it, troubles for an EU member doesn’t directly connect to the US dollar – however, few things in global markets follow straight paths. The global implications of this particular situation are particularly vast. Over the past week, the effort to keep a member of the EU (the world’s largest collective economy) from falling into default was made exponentially more difficult when the nation’s prime minister (George Papandreou) was forced to shuffle his cabinet and call a vote of confidence. Considering the ‘trioka’ (EU / ECB / IMF) was already facing considerable troubles to meet a resolution on the nation’s second bailout; the addition of a more demanding Greece in the negotiations will only make matters worse. A short-term fix will be put in (Germany already seems resigned to abandon demands for a rollover in bonds to a seven-year maturity); but that is for the next tranche of aid from the first package. So what impact would this have on the dollar?

Depending on how effective the band aid is perceived to be by the market; the Sunday meeting about meeting the next round of support for Greece can temporarily curb the pressure on the capital markets and cool its support for the greenback. On the other hand, should the market turn skeptical on the ultimate outcome for this effort or find a road block on progress altogether; the there will be three points of support for the dollar. The first boost is the most straightforward – fear of a financial crisis for the euro-area will encourage foreign investors to pull their capital and put it in an alternative market with equivalent liquidity: the US. Perhaps just as familiar to FX traders is the impact this event can have on risk appetite trends. Fallout from a Greek default would have immediate implications for many fellow EU members that have exposure to the nation’s public and private debt. More importantly, the sudden rush of capital to ‘safe’ assets will further ripple effect to global equities, speculative commodities, debt markets – and the US dollar as a currency of last resort. The greenback’s safe haven appeal is unique in that it stands out when there is a need for liquidity (the ability to access your money).

During the 2008 financial crisis, the sudden collapse of the mortgage-backed and other derivatives markets threatened the liquidity of even the most liquid (money markets); and the US market’s shone as the world’s most liquid. This is the ultimate ‘risk’ impact for the risk/reward balance. On the other side of that balance we have the eventual rebound in US rates. The QE2 program is scheduled to end with this month; and the Fed won’t withdrawal all of its capital immediately. That said, the market will start pricing in that outcome.

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