Dollar Ready to Rally as Europe Devolves into Crisis, G20 Sanctions Speculative Capital Curbs

Dollar Ready to Rally as Europe Devolves into Crisis, G20 Sanctions Speculative Capital Curbs

The dollar’s performance Friday was relatively disappointing on a close-to-close basis. Though volatile and setting a new monthly high on a trade-weighted basis early in the session, the currency would ultimately end the day little changed and slightly in the red. However, this particular aspect of performance is not what we should be concerned with. The fundamental and speculative potential lying ahead of the market is what we should be focused on. While it is no guarantee, the capital markets are at their greatest risk of reversal since the most recent bull phase began back at the start of September. We can see this potential in the benchmarks for investor sentiment and capital flows. In equities, the Dow Jones Industrial Average has tentatively broken its multi-month rising trend with a move below 11,200 – even though the S&P 500 has yet to do the same. For commodities, crude has suffered a massive reversal and gold put in for its biggest decline since July 1st. Even corporate bonds and Treasuries have taken a hit. This same sense of risk can be established in the currency market. Favorite investment currencies have started to retrace gains while overlooked safe havens have put in for a slow recovery. This shift led AUDUSD to drop back below parity and USDJPY has even threatened its long-term bear trend. Yet, it is EURUSD that will likely benchmark the dollar’s future.


Through Friday’s close, we have seen the foundation set for a few very important fundamental trends that stand to significantly benefit the greenback. Among the three top catalysts for the currency are the potential for speculative curbs to retain US capital in US investment, a European crisis spurring reinvestment to the liberally-supported US market and a general deterioration in risk appetite trends. In reality, all three of these dynamics would likely work in conjunction; but any one of them could spark a meaningful recovery for the dollar. The first driver to highlight was put into action Friday; but it could potentially take time to develop. From the G20 statement that followed the close of the two-day meeting, it may seem that policy officials avoided a meaningful effort to collaborate on exchange rate volatility and isolated asset bubbles. Yet, one notable feature that should not be overlooked is the endorsement for emerging market economies to adopt regulations aimed at curbing capital inflows. On the one hand, this can make a meaningful dent in the development of asset bubbles and it will certainly cool risk appetite. But, more than that, reducing the options for high return means investors will be less likely to take on cheap leverage in the US and place subsequent yield bearing positions elsewhere (a process that naturally includes selling dollars). Instead stimulus will be put to work in on the US market.


In comparison, financial troubles in Europe have only started to gain traction as a catalyst. That said, this particular theme could easily be the dollar’s top driver in the near future. This past week, we have seen yields on sovereign debt and credit default swaps for key European economies surge to record highs. Given the long-term troubles this region faces and the market’s growing uncertainty, authorities may be forced to act with another bailout. This would boost the appeal of the dollar two-fold. First, such a move would undermine the speculative drive that has inflated capital markets the world over. While there will be some latent sense of the dollar offering a safe haven, it will more importantly see inflows on the unwinding of positions that were founded on US-based stimulus. What’s more, the liquidity between these two economies will naturally direct capital from Europe to the US. Now we wait and watch to see what happens across the Atlantic.


Related:Discuss the Dollar in the DailyFX Forum, John’s Analyst Picks: GBPUSD Takes Profit, EURUSD Top Concern Next Week


Euro: What is the Likelihood of a Second Crisis and How Would the Euro React to such an Outcome?

The euro was the fundamental focal of the currency market Friday. Third quarter GDP readings for the region reported modestly below forecasts. However, missing expectations wasn’t the full extent of this data. Its real influence would be found in the woeful comparison between stalwart Germany and those EU members that are struggling - and failing - to balance austerity with growth (Greece, Portugal, Spain). Where fear really comes into the picture is the pressure such important data adds to the already fragile financial system. Yield spreads on Irish, Greek and Portuguese government bonds accelerated their surge to record highs. And, it seems at least one of these economies is nearing a breaking point. According to a Reuters report released Friday, unnamed EU officials said Ireland is in fact seeking rescue funds.


Whether the Celtic Tiger has put its hat out or not will be the top concern going into next week. If they have indeed asked for assistance, they will almost certainly receive it. Where the scenario really becomes interesting is establishing how such a move would impact the euro. A bailout would curb fears that the Irish government will be swamped and may stall gains in yields. However, looking beyond the very short-term, this move will be seen as a clear step towards more stimulus (akin to the US) while the moral hazard and effectiveness concerns will balloon.


Japanese Yen will Have to Prove Itself as Risk is Stirred and 3Q GDP Data Quickly Approaches

Once again, FX traders are distracted by heady fundamental concerns. A potential European crisis can keep the yen stationed as a safe haven alternative – though near record highs, it will be interesting to see how far this scene can continue to play out. Perhaps the 3Q GDP figures due very early Monday morning in the Asian session can help remind investors of the Japanese currency’s own troubles.


British Pound may not Enjoy its Stimulus-Postponement Rally for Long

The 19-month low in the Nationwide Consumer Confidence survey would have relatively little influence over the sterling Friday. Instead, pound traders are more concerned about the future. On one hand, the market is wary of the spillover effects of a Euro-Zone financial crisis. On the other, we have growth and inflation data from the UK due next week which can help to redefine stimulus and interest rate speculation.


Australian Dollar: A Hearty Fundamental Backdrop can Prevent a Major Selloff but not a Risk Reversal

If risk appetite is collapsing, it is a relatively straightforward assessment to say the Australian dollar will suffer. The unwinding of speculative positions will naturally weight he currency. However, in a market where everything is relative; we should consider the Aussie’s performance against say the kiwi. The Australian dollar has the yield, growth and financial stability to sustain itself. Expect a decline here to be less dramatic.