Fundamental Forecast for Dollar: Neutral
After a disappointing week for yields – despite robust commentary – rate forecasting will focus on Yellen’s testimony
Volatility started to move off its historical and seasonal lows last week, but the dollar awaits a true turn
Dollar Index continues to linger conspicuously close to a level that has held the floor on the currency for the past 16 months. Whether the assessment is technical or fundamental, the signs point to a meaningful break for the greenback in the near-term future. However, the direction the market chooses and the commitment to a new trend’s continuity depends on how underlying market conditions evolve and whether the rate forecasts start to solidify.
Perhaps the dollar’s greatest burden moving forward is the maintenance of long-standing complacency
in the broader financial markets. Status quo supports the market’s
appetite for greater rates of return – even when that pursuit
necessitates borrowed funds and greater exposure to fulfill. This all
but deflates the currency’s dormant role as a liquidity-centered safe
haven currency – an uncontestable position…so long as the market is
seeking it out. Furthermore, complacency delays rate expectations for
the Fed taking shape across the speculative ranks.
The most capable fundamental catalyst the dollar could face moving forward is a definitive development in risk trends. Yet, here, there is asymmetrical potential. A true and committed swell in speculative appetite that charged high-yield, high-return assets would certainly divert capital from the relatively steady but modest returns in the US. That said, against record use of leverage in the financial system and the premium nearly rung dry from so many of the favored – and even obscure – income assets, it is difficult to inspire a groundswell of risk appetite from current levels. So while it is certainly possible that we meander at exceptionally low market activity levels, the damage from the theme is disproportionate.
Though we seen a number of false dawns before, there was some hope that volatility may be turning a corner this past week. Volatility measures from both the capital and FX markets moved up from their lows. Historically, July sees the biggest average increase in the activity report of any other month – a seasonal shift that can perhaps provoke a turn from the historical depression in these measures. Should market volatility pick up meaningfully, the market’s positioning could prove its undoing. Record highs, record leverage and historically low premium afford little room for a breather before it encourages panicked deleveraging.
Pegging events or data as certain catalysts for speculative impact is difficult. Europe’s recent banking concerns, monetary policy programs changing course and Chinese 2Q GDP are all notable but far from certain influences. When sentiment does sour, it will likely be self-reinforcing. Yet, the initial spark may seem relatively insubstantial (often called the butterfly effect).
Aside from the nuance of risk trends, interest rate speculation promises to be relatively straightforward. This past week, FOMC minutes, Fed member speeches and data seemed to reinforce the idea that the central bank will hike by mid-2015; but neither currency nor yields bore that expectation. Treasury yields may be falling as a side effect of safe haven demand stoking their price, but Fed Funds futures have similarly receded over the period. There is a large discount in the market’s forecasts to even the Fed’s own view of rate forecasts. This presents yet another unbalanced impact potential: not much room to deflate but plenty of scope to swell.
Amid data that ranges from economic health (UofM consumer sentiment, retail sales) to financial activity (TICS flows) to inflation (factory-level price indexes), the most concentrated potential for rate speculation rests in Fed commentary. Speeches by Fisher and Bullard aside, Chairwoman Janet Yellen is scheduled to give her semiannual testimony before congress on Tuesday and Wednesday. Direct questions on growth, stimulus, capital markets and other key topics should capture the market’s interest.