Dollar Will Keep Its Bid as Fear Continues to Win Out Against Hope

Dollar Will Keep Its Bid as Fear Continues to Win Out Against Hope

It was an appropriate way to end the week. The Dow Jones FXCM Dollar Index Friday cut its smallest daily range in four months as those traders that stuck around for much of this week for the off-chance of a market collapse unwound into the extended holiday weekend. As with the benchmark S&P 500, the greenback is looking to end this year little changed from where it began. However, the volatility that we have seen these past 12 months speaks to the bigger fundamental conflict behind the capital markets: the knowledge that yields and growth are deteriorating against the hope that stimulus will keep markets stable. This is a dangerous balance – evidenced by the exceptional swings and the surge in central bank balance sheets through the year. Yet, it could be considered a successful effort if the alternative was a full-blown crisis.

Heading into the new trading year, the headwinds of economic and financial strain will quickly return to unsettle investors. Given the progressively diminished influence of policy actions taken by the Fed and European authorities through the past year; it is reasonable to argue that skepticism and deleveraging are the dominant trend. The QE programs, government bond purchases, liquidity infusions, guarantees and other efforts have been the only thing holding back the tide. And, with the market’s building immunity to the temporary effects of intervention; these programs will have to be implemented more rapidly or come in greater size to maintain current asset values much less encourage further appreciation. There is still scope for officials to put up a fight; but without a natural return to economic expansion and investment, the sheer weight of the market’s deleveraging (there is a lot of exposure to work down) will overwhelm the sizable but limited support that can be raised.

For the dollar, the constant threat of a market-wide collapse in sentiment is very promising. Just as the greenback surged through the fourth quarter of 2008 on a financial crisis that began in the United States, the currency will certainly follow the same path with a euro-born spread that undermines its only practical substitute as a reserve currency. That said, with each effort to put out the flames, the dollar will come under pressure. Even a period of stability curbs the need for an absolute liquidity currency with little-to-no yield potential. Moving forward, dollar traders should monitor the health of the global financial markets with specific attention paid to the active European crisis.