Dollar’s Rally has Collapsed and only Risk Aversion can Salvage It

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By John Kicklighter | December 5, 2010 3:03 AM EST

DailyFX

Dollar's Rally has Collapsed and only Risk Aversion can Salvage It

Fundamental Forecast for the US Dollar: Neutral

The dollar has seen a dramatic reversal of fortunes this past week - and this shift in performance accurately represents the reversal of fundamentals that initially lead the currency to its remarkable gains. If we assess the greenback for its long-term and underlying fundamental traits; it is not difficult to see that the there is a meaningful effort to diversify away from the benchmark as a singular reserve and a more immediate effort (though it may not be the direct intention) by the Federal Reserve to inflate the money supply and thereby depreciate the value of the currency. These two concerns exert a constant pressure on the dollar; but they do not have to claim responsibility for the day-to-day and week-to-week activity for the currency. The dull droning can be tuned out or amplified with the proper developments. That said, the dollar's most prominent support in six months may have evaporated.

To offset the ever-present threat of diversification and the natural depreciation in the expansion of dollars in the system, the greenback needs a powerful driver to encourage a bid in the FX market. Through November, the ranks effectively found that source of strength in two stages: first, the currency would naturally correct after speculation surrounding the Fed's efforts early in the month was proven oversaturated; and then troubles emanating from Europe's financial markets would open the tap for European capital to flow to the US. There is certainly a risk-appetite element to the possibility of a crisis emerging in the Euro Zone; but the headlines would have only limited impact on equities (the traditional barometer for risk). However, a more structural element to this equation is the fact that investment capital will avoid uncertainty and seek out both liquidity and stability.

This appealing combination would guide capital to the dollar through the second half of November. However, without a constant deterioration in European health, the tables would eventually balance. And, that is what seems to have transpired this past week. Fear essentially forced Ireland into seeking a bailout; and while Portugal and Spain seem questionable, there does not seem enough will to back them into the same corner. So, with the ECB buying up government bonds, authorities are looking to defuse the situation and therefore rob the dollar of a key booster.

Anti-euro flows can still help the dollar to gains going further; but leveraging that kind of interest again would likely take a remarkable event. Instead, the most highly-charged, potential driver for the dollar going forward (be it bullish or bearish), is the bearing of risk appetite. The S&P 500 and other benchmarks have held stubbornly buoyantthese past weeks despite financial troubles, questionable economic data and geopolitical issues. This is almost certainly a direct effect of government stimulus and guarantees on capital markets; but this buoyancy cannot be maintained forever. Eventually capital will collapse on itself; but what will be the final straw? -JK

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