Why the Dollar Will Surge if the Dow’s Slide Accelerates
Fundamental Forecast for US Dollar: Neutral
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Economists survey show probability for September Taper hits 65% but reduction only $10 billion
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GBPUSD among the majors positioned for a dollar turn?
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It’s a relationship that has many FX traders scratching their heads. The Dow Jones Industrial Average has marked a painfully-obvious technical breakdown, and yet the renowned safe haven US dollar is still threatening to collapse into plunge itself. Yet, don’t position for AUDUSD and GBPUSD rallies just yet. If the equities’ stumble turns into wholesale deleveraging, the greenback will soar.
In an ideal world, the standard lines of fundamental analysis would be clear cut and immediately accessible. However, in the financial markets where thousands of variables dictate where millions of traders position their capital; it is unwise to expect an easy navigation. Simple and straight forward trends in the chaos of a multivariate market develop when the vast majority of participants (or at least the capital that they control) are positioning towards the same goal. Few ‘themes’ can align such a behemoth, but risk appetite and the influence of a central bank are certainly two that can top the list.
So, that brings us back to the dollar’s performance this past week. If the Dow and S&P 500 marked inauspicious reversals, why did the reserve currency not surge in response? While the equity tumble is certainly menacing, it has yet to shake the foundations of investor confidence. A basic challenge to cries of a full-scale fear move would be reservations of the market-favorite VIX Volatility Index. While the ‘Fear gauge’ rose to its highest level in six weeks, the 14.4 percent reading is barely off five-year average lows and a third lower than the post-June FOMC rate decision swing high.
The ultimate consequence of a market-wide risk aversion move is the unilateral transfer of capital away from assets deemed risky and into those that provide liquidity and stability. Such a stampede easily jumps the boundaries of asset classes. However, it is not easy to escalate concern to that level. Over the past weeks and months (even years), there has been a steady buildup of fundamental motive to see record high capital markets and carry trade turn. Leverage use hit record highs, participation has troughed to 15-year lows, real rates of return slumped and a dependency was developed around central bank support. While each of these issues is troubling, they don’t necessarily sink the market. A catalyst needs to start the ball rolling and align traders’ fears.