Dollar Rally to Three Year Highs Only Accelerates as Taper Fear Rise

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Dollar Rally to Three Year Highs Only Accelerates as Taper Fear Rise

Fundamental Forecast for US Dollar: Bullish

The dollar was the clear winner this past week. The benchmark reserve currency climbed against all of its major counterparts over the period while the Dow Jones FXCM Dollar Index (ticker = USDollar) extended its impressive rally to a third week as it move to three-year highs. Meanwhile, the market’s greatest threat moving forward – the possibility of a mass deleveraging sparked by risk aversion – poses a significant bullish ramp for the safe haven greenback should such fears befall the speculative ranks. That is not to mean that counter-trend corrections aren’t possible – idle markets are a passive risk to the currency’s incredible momentum – but the headline and unpredictable developments that threaten to creep in are distinctly supportive of the current run.

First and foremost, the greatest contribution to the dollar’s rally to this point – and thereby our active concern for the week ahead – is the growing acceptance that the Federal Reserve is on pace to reduce its monthly stimulus purchases (from $85 billion) by September. Aptly named the ‘Taper’, such an eventuality holds significant influence over the performance of the markets moving forward. Over the past four years, the capital markets have soared despite uneven growth, tepid investment turnover and historically low rates of return. While initially this move was directed by a reinvestment after the Great Recession and Financial Crisis of 2007-2008, it transitioned into a move fed by an elemental aspect of investment: greed. Stimulus championed by the Fed drove lending rates to record low and led investors to believe that risk was all but eliminated. Yet, that collective faith fed by moral hazard has been shaken by fear of the Taper.

When Fed Chairman Ben Bernanke remarked in the press conference following the June rate decision that tapering can begin later this year and end by mid-2014, it was a clear shift in the benchmark outcome for the bank’s next move. Since then, we have not seen anything to deter theTaper time table that has become the consensus. Scheduled speeches by Fed officials have tried to temper the reactions to the expected outcome, but they have clearly not contradicted the forecast. This past week, the June employment data accomplished the same. More important than the payrolls change, the Fed is targeting the unemployment rate; and that was where the market was looking. The 7.6 percent print didn’t tick lower as expected, but it is just off the lowest level in four years.

It is the jobs report that perhaps best illustrates the situation we currently find ourselves in. The market’s expectations for the Fed to pump the stimulus breaks within three months is quickly becoming the consensus, and the influence is seen in FX, Treasuries, high-yield assets and even equities. However, dependency is difficult to break; and room for doubt has allowed some assets room to revert to blissful ignorance until the very last moment.

In descending order of influence, we have first seen the Treasury and Mortgage-Backed Securities bond funds take the first and heaviest hit. The targeted assets of the Fed’s stimulus regime, these are speculators’ favorite trades to ‘front run’ the Fed. It so happens that they are front running well ahead of the exit as well. Next, we have the US Treasuries (government bonds) themselves. The benchmark 10-year yield has surged nearly 70 percent (1.12 percentage points) in less than two months as the market’s biggest buyer is contemplating reducing its pace of buying. Then we have the dollar. Pushing to three year highs on the back of a 5 percent rally. Curbing the ‘supply side’ of the fiat currency and seeing the eventual implications for risk aversion, the greenback is a clear benefactor.

The hold out is equities – I like using the S&P 500 for my benchmark. Just off record highs and built upon record levels of leverage while participation stands near the lowest level in decades; there is a distinct risk of panicked deleveraging should sentiment falter on this particular asset class. When does this domino fall? It is difficult to say, but the heavier the sense of risk aversion; the more likely we light the fuse. It is possible that the Fed responds should a pullback become too unwieldy, but they are unlikely to continue preempting simple corrections as they find their self closer and closer to the end of their rope – where they couldn’t answer actual growth, stability issues.

Always on the lookout for sparks of fear, the coming week has plenty of event risk that we should account for. Distinctly US, we have Bernanke and a few other Fed officials speaking; the start of US 2Q earnings season; long-dated maturity Treasury auctions; and a smattering of data. However, a Euro-area crisis, Chinese growth crisis or other major development may be more effective. – JK

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

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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