Fundamental Forecast for US Dollar: Bullish
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Fiscal cliff discussions shift from ‘confident of a compromise’ to ‘stalemate’
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Consumer confidence jumps to its highest level since February 2008
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Will the dollar post reversal against the euro and yen?
Just a cursory look at the US Dollar chart and we can feel the pressure building. On an activity basis, the benchmark currency index (ticker = USDollar) is carving out its smallest range (using a two-week ATR reading) in years. In contrast, the fundamental risks are lining up with the Fiscal Cliff rhetoricescalating and Euro-area crisis resolution skepticism reaching new heights.
The ingredients are there for a serious breakout, but there is a critical catalyst that must make an appearance first: volatility. Normally, we would look at the economic docket or event risk that can stir the bigger fundamental themes. However, this time around, our focus must turn to a far more elemental aspect of market activity. Without it, the dollar will remain stationary, risk trends will flounder and volatility will continue to deflate to fresh five year lows.
The elusive factor for tipping speculative appetite and driving a clear trend is participation (‘volume’ or ‘open interest’ in trader parlance). If market depth thins out, there are fewer investors available to drive a move that sees a buildup in risk assets or feed a steady risk aversion move. On one hand, it is difficult to attract bids to buy at higher highs (pushing a bullish trend higher). On the other, if there isn’t a significant pool of uncommitted traders (ready to unwind their exposure under relatively mundane losses); a deleveraging initiative will just as quickly run out of steam.
For traders, a strong historical correlation between volume, volatility (the VIX Index) and risk trends marks a clear causation chain. For the US dollar to catch traction, we need to leverage its reserve and safe haven value. In other words, we need to see a risk aversion wave sweep over the market. A plunge in sentiment generally leads market participants to buy up ‘insurance’ in the form of derivatives – as it is sometimes unfeasible to simply liquidate. That insurance cost is reflected in our traditional volatility measures (most often backed out of options prices as the only unknown variable). That is why we the VIX and FX VIX indexes are considered ‘fear’ indexes. From there, the more exposure there is and higher (volume) the market levels, the more insurance is needed.
Incorporating the tepid participation factor into the equation, the five-year lows in the Forex volatility and stubbornly buoyant S&P 500 (and other risk benchmarks) makes more sense. It also presents a major hurdle to pulling overextended markets back to more reasonable levels to entice sidelined capital back in to the market.