Fundamental Forecast for the US Dollar:Neutral

It wasn’t just the dollar that opened this past week backed by a strong fundamental wind. Global investors sentiment was severely shaken by the suggestion that Greece’s Prime Minister was pushing through a vote on the EU’s austerity plan, which could have essentially been read as a vote on the countries membership in the EU. A direct escalation of the market’s hot spot for crisis; the fear engendered from this particular event was more than enough to drive capital away from all things ‘risky’ and into the relatively safe confines of the US dollar and its Treasuries.

However, now we know that the Greek threat of default and/or EU withdrawal was a political move to leverage support from a split parliament. Going forward the market will be more reticent to follow similar catalysts. This will not, on the other hand, necessarily dampen volatility in the balance between high returns and safe harbor for speculative capital. Since the dollar is not particularly sensitive to its own fundamental developments (the Fed has vowed to keep benchmark rates near zero until mid-2013 and the road to a strong economic recovery will no doubt be very long); we will have to look to the quality of sentiment and its catalysts going forward.

An immediate driver to start next week may be the reaction to the Greece confidence vote. With Prime Minister Papandreou surviving, the country has essentially moved forward with approving the austerity measures the EU/IMF/ECB require in order for the EU member to receive the assistance agreed to in the October 26th Pact. There is still the possibility the new unity government may not be able to garner the necessary support to stay the course on austerity; but there are a number of weeks before such an issue would create a real problem for regional (and global) financial stability. This is another lingering issue whose resolution will be pushed back a little further.

In the meantime, the bearing on market-wide sentiment trends and thereby the greenback will still be determined by threats to financial stability. Yet, the focus now is turning to much more intrinsic and pervasive elements of the system. A serious concern in the market backdrop is the persistent slide in liquidity and surge in demand for so-called ‘risk-free’ assets – which suggests a lower tolerance for anything risky and greater attraction for safety. Taking the temperature ofthe funding markets (the lifeblood of finance), we note that the cost for banks to borrow funds in the US (the three-month Libor – overnight index swap spread) has risen to its highest level since July of 2009. Signaling the spread of contagion from the Euro Zone, foreign short-term loans (repos) with the Fed has surged to a record high this last week. In the meantime, the US benchmark 10-year Treasury yield is quickly closing back in on its record low (set in September) while its European equivalent in the German 10-yr Bund has just off its own record low.

With the progress of the world’s next crisis spreading out from Greece to other sovereigns (Italy seems in serious risk now), European banks (Dexia, Societe Generale, Unicredit, etc), and now showing a clear impact on US liquidity and banks (MF Global); we see the same dangerous spread that happened back in 2008. This will be a slow development in the background; but the dollar will respond to is the catalysts that bring the threat to the forefront and thereby stokes panic that drives capital to safety.

Looking for set events to stir risk next week, there is nothing on the docket that has the clout to seriously alter confidence on a global scale, so we will have to be tuned in to big headlines. In the meantime, top event risk is the University of Michgan sentiment figure. - JK

--- Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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