US Dollar: Policy Tightening and Mounting Risk Build Bullish Pressure

Written by dailyfx.com

Fundamental Outlook for US Dollar: Bullish

 

-    The Federal Reserve hikes the discount rate, adds to speculation that Fed Funds rates will soon follow

-    Risk trends compete with interest rate forecasts for the dollar’s attention

-    Was the Dollar’s late-week rally for naught or has the currency seen a critical extension of a larger trend?

There is a reason the Federal Reserve decided to announce the first hike in the discount rate since 2006 after the market’s close this past Thursday. With a precedence of jittery responses to stimulus withdrawal in other countries (most notably the hikes to China’s reserve ratio); the central bankers were concerned such a move could trigger a panic among speculators born from the fear that the fuel for 2009’s rally was disappearing. However, after an initial rally from the greenback immediately after the release; the currency tempered its gains. As much as the fundamental and interest rate backdrop is improving for the US; underlying risk trends are still the primary guide for the benchmark currency. Yet, this connection hasn’t condemned the dollar’s rally. A comparison between the Dollar Index and the Dow Jones Industrial Average these past few weeks shows something quite unusual: a positive correlation. Has something fundamentally changed for the currency or in the global financial market?

Recent history has shown us quite clearly that the US dollar has been an ideal safe haven and funding currency. Yet, if that were the case, we would expect the build in risk appetite and carry that rising capital markets should have supported this past week to weigh the greenback down. Yet, there are a few unusual factors at play. First, for the undercurrent in sentiment, while some of the growth-linked benchmarks have indeed trended higher; this is more a stabilization and reversal of the late-January / early-February slump in risk appetite than a true rebound in optimism. There are many reasons to be concerned over the stability of financial markets and the nascent economic recovery. From the start, the potential for expansion and returns inherent in the otherwise tepid recovery from the worst financial crisis in modest history already reasons asset prices are misaligned. However, the conviction of greed (risk appetite) can keep trends in place longer than fundamentals would otherwise support. What is needed is a catalyst to break this conviction. The greatest threat to stability is without doubt the situation in Greece. While concerns over the nation’s deficit seem to have subsided; the threat to broader Euro Zone is undeniable. All that is needed is a spark in sentiment for this situation to once again erupt. In the meantime, China could once again roil the markets (and perhaps set off the dominos in Europe). The Far East market is set to open for the first time in over a week; and this epicenter for speculation has yet to price in the most recent reserve ratio hike, not to mention the other developments.

Another consideration is the influence that the hike in the deposit form this past week can have on the dollar. There are two distinct impressions this move has. First, this move helps normalize the monetary policy in the US and moves up the time table for an eventual hike to the Federal Funds rate. Another consideration is that this move has the same implications for risk appetite that the increase in the Chinese reserve ratio had: this is a move that is withdrawing the same stimulus that has facilitated the market’s recovery over the past year. We have already seen the immediate reaction to this data; but don’t expect this development to have already played itself out.

As for scheduled event risk on the docket; there are many big ticket names. However, don’t expect a second reading of GDP, durable goods or consumer confidence numbers to distract the market from the bigger, more pressing themes already in motion. - JK