Is This The Dollar Breakout?

Daily Forex Fundamentals | Written by DailyFX | Aug 08 08 21:33 GMT |

August 8th, 2008 will be known for two events: the start of the 2008 Beijing Olympics and the massive, bullish breakout for the US dollar. The currency made its move across the board, taking out significant technical (and psychological) levels against most of its major counterparts and marking its biggest one-day advance on a trade-weighted basis in over fiveyears.

Five months after testing a record low and through four months of congestive price action, fundamentals have slowly built up (though the US data hasn't exactly been encouraging) behind an eventual rebound in the massively oversold currency. With liquidity draining for the weekend, the market now has time to contemplate: is this the true trend reversal and how will this effect my trading in the long term?

Shifting Gears On Fundamentals

Getting to the point where traders and economists are debating whether or not we have entered a new bull leg for the dollar - where until recently the consensus was the currency would soon be replaced as an anchor to pegs and could lose its status as the world's leading currency to the euro - took time and a global economic slowdown that would ultimately leave the beleaguered US with the most impressive balance sheet.

Since last summer's subprime meltdown, the Federal Reserve has cut the benchmark lending rate by 325 basis points, the housing sector has entered a recession not seen since the Great Depression, and employment numbers have contracted for the longest period since 2005. With conditions like these, why would the greenback be on the verge of a major advance? The answer is simple. Because despite the United State's current predicament, the outlook for the world's largest economy is fundamentally better than that of its industrialized counterparts.

From a growth perspective, revisions to annualized GDP numbers show that the US contracted for the first time in six years through the final quarter of 2007. However, by the time this slowdown was confirmed, more timely data was already suggesting the worst has already passed with second quarter growth figures reporting 1.9 percent expansion. For a fundamental backdrop that has been completely overshadowed by consistently disappointing data, this broad reading alone has catalyzed confidence that recessions in certain areas of the overall economy will be leveled out by strength in others. In contrast, the forecast for other economies is deteriorating. The Euro-Zone GDP number due next week is expected to match its slowest annualized pace in four-and-a-half years as domestic spending falters and exports suffer from curtailed demand and unfavorable exchange rates. In the UK, the local housing recession is already the worst in recent history and it looks to worsen with time. Add to that, inflation that has stifled business activity and consumer spending; and projections for growth are low. Finally, there is Japan. The Asian giant has struggled since the late 90s financial crisis, and recently consumer spending and a housing slump has slipped into critical levels. To top it off, for the first time since 2001, the Japanese government's assessment of domestic growth was downgraded to ‘weakening' - what many consider an admission that the economy has already entered a recession.

Interest Rates' Contribution

A partial reflection of long-term fundamentals (but the primary driver for the currency market), interest rate expectations have also taken a dramatic turn in the past six months and even in the past few weeks. While current benchmark lending rates are still heavily skewed in favor of those well known carry currencies (the New Zealand Dollar, Australian Dollar, Pound), their forecasted change over the coming 12 months priced into overnight interest swaps offers the road map for speculation in the underlying currency pairs. From the spreadsheet below, we can see that at the beginning of the year, the market was expecting 104 basis points of easing through the following 12 months (the Fed actually cut 100 basis points through the first half - leading the dollar to its record lows). Since then however, the outlook has changed dramatically, with 78 basis points or roughly three quarter-point hikes expected by next August. The expectations for all the other major central banks are no where near this change, and the ECB, BoJ, RBA and RBNZ have actually turned negative.

The Outlook

Today's dollar rally easily marks a technical turning point for many of the most liquid dollar-denominated majors; but the currency certainly hasn't cleared all hurdles. Technically, while EURUSD and GBPUSD have dropped below major support at 1.5300 and 1.9400 respectively, there is still resistance for the greenback on a trade-weighted basis. A look at the Dollar Index reveals the dominate trend from the late 2005 bearish trend reversal has yet to be tested. This will no doubt require significant momentum on the dollar's part to charge up enough strength to breach such a noteworthy level.

The fundamental scene is even more difficult to reconcile with a sustained dollar rally. While its major trade partners are just now catching the same cold that the US has been trying to shake, conditions in America are still worse. The housing recession is deepening, business investment has dried up, lending has frozen and now the consumer (the largest component for economic growth) is being assailed. Combine an unemployment rate at a four-year high and wage growth slowing to a two-and-a-half year low with inflation not seen in 17-years and we have sentiment near three decade lows. If the consumer sector falters, the chances for GDP to further rebound on the virtue of exports alone are slim. In turn, concerns of a recession would offer no confidence for rate hikes.

For the dollar to maintain its current trajectory and confirm a major trend change, the currency and economy will need to answer these issues. Regardless of the technical breaks in the majors, the dollar will need to break resistance in the trade-weighted index. For the long term, the fundamentals will need to back the dollar fully. Growth factors will grow increasingly important - specifically consumer spending and sentiment, business activity, trade and the housing market will need to show genuine evidence of a bottom. Ultimately, though, the true determinate will be interest rate expectations. Three quarter point hikes are scheduled for the coming 12 months, but such a major exchange rate event will need confirmation of just such a monetary policy change early in the forecast period. What's more, a Fed hike would need to outpace any hawkish ambitions from other central banks.

DailyFX