Dollar Posts Biggest Weekly Rally In 6 Months

Market conditions can supersede both fundamentals and technicals – a truism we witnessed this past week. Typically, the dollar’s position as the preferred reserve currency would have leveraged a selloff with the S&P 500 posting its biggest rally in 13 months. In fact, the Dow Jones FXCM Dollar Index (ticker = USDollar) enjoyed its strongest advance in six months over the same period and closed at its highest level since July 25. This unusual correlation between underlying risk trends and the safe haven dollar was facilitated by both the extremely low levels of speculative participation through the passage of the holiday period as well as an intense focus on the on the outcome of the US Fiscal Cliff.

Though pushing the decision beyond the technical deadline, the US government managed to hammer out a solution to the impending doom of automatic tax hikes and spending cuts. Naturally, removing the risk of a sure push into recession for the world’s largest economy lifts a serious cloud of uncertainty and bolsters risk appetite – thereby driving equities and other "riskier" assets higher. However, the dollar also benefits from this turn as the threat of a critical sovereign credit rating downgrade (a move that hits at the dollar’s core value as the benchmark currency) evaporates as well. That being said, the positive correlation between risk trends and greenback is unlikely to last for long.

A relief rally for the dollar via reduced rate cut fears has an exceptionally short shelf life. That doesn’t mean we should expect the dollar to simply tumble into a new bear trend though. The "solution" offered up for the Fiscal Cliff, was merely a band aid that carries us over to the bigger threat of a standoff on raising the debt ceiling. The Treasury runs out of extraordinary means for preventing the US to breaching its debt cap sometime in mid-February and the so-called ‘sequestration’ – or $110 billion in automatic spending cuts – is set for March 1. This can easily set risk trends on fire once again and thereby benefit the safe haven status of the dollar. The deciding factor is whether investors look ahead or enjoys the brief calm.

As we establish the next phase of the US fiscal crisis, there are other considerations for risk and dollar traders to consider. Though not fully engaged, there is a shift in comfortable expectations for Fed stimulus to remain a driving force for years into the future. After the Fed minutes this past week showed growing support for the $85 billion-per-month QE purchases of MBS and Treasuries by or before the end of 2013, the tepid growth outlook and extreme lows in investment returns look far more daunting to the long-term investor. For a more concise time frame, we will watch the reaction to the beginning of the 4Q earnings season with Alcoa reporting on Tuesday and Wells Fargo on Friday.

Euro Struggles Before ECB Adds Weight
A rebound in risk appetite often has a forgiving influence for currencies or assets that maintain a questionable fundamental outlook. We have seen the general rise in sentiment tides lift the troubled euro numerous times in the past, but the currency showed little of that strength over the past week. Aside from EUR/JPY, the euro lost ground against all of its freely-floating, major counterparts. This may be a sign that the relief of Greece avoiding catastrophe has been spent.

Another consideration that is often overlooked – the euro’s benchmark Libor and Treasury rates are lower than its US counterparts’, which may actually drive carry interests away from the euro. Looking to the week ahead, there is plenty of event risk in sentiment measures (investor, consumer, economy), an ESM bond sale, a number of meetings for officials and Greece unemployment. Most euro traders’ top concern though is the ECB rate decision Thursday. The risk is for further cuts to rates or growth forecasts.

Japanese Yen Crosses Extend Rally to New Highs
The yen’s tumble continued with little check this past week. Though the foundation of risk trends were somewhat dubious, the safe haven and carry funding currency didn’t shy away from a hearty drop against all of its counterparts. Between a 1.3 percent drop against the euro (a weakened currency) and 4.0 percent plunge versus the New Zealand currency, this tumble is extremely stretched. The implications of a natural correction would find serious leverage should a bout of risk aversion kick in. If fear rises, there isn’t much carry to in these crosses to buffer it.

Canadian Dollar: FX Traders Pay Little Heed to Strong Jobs Numbers
Once again, the Canadian docket would impress on employment. The payrolls figure roundly beat consensus with a 39,800- position increase and the jobless s rate unexpectedly dropped its lowest level since December 2008 (7.1 percent). However, this times, the Canadian dollar ("loonie") paid little mind to the positive report. The NFPs report at the same time offered some distraction, but there is further an issue that the market is growing acclimated to "beats" by this data series. Once again, loonie traders must focus on risk trends and symbiotic USD trends.

British Pound Excessive Tumble May Spur Rebound
Over the past three days, the sterling has enjoyed the worst performance amongst the majors. Whether against high yielding counterparts or safe havens like the dollar, the pound was the most afflicted of its counterparts. This intense decline has some grounding in data (like the Services PMI) and the lagging pace of government bond yield growth; yet it is still arguably overdone. Be careful of a speculative reversal.

Swiss Franc: Safety Flows and SNB Reserves Still Issues
Though the panicked drive behind the flight to safety for European capital has let up, the franc is still a shining beacon for investors and citizens that realize the larger issues are far from resolved. The SNB’s report of its foreign currency reserves this coming week will be interpreted for its influence on keeping the franc suppressed. Traders should keep a vigilant eye on EUR/CHF for any serious changes in interpretations.