Forex Investment and Currency Trading

• The risks in the near term seem to be skewed towards further deleveraging and related strength in the Dollar and low yielding currencies.
• Beyond the funding and deleveraging issues, the outlook for the Dollar would still be dominated by some clear Dollar negative forces.
• US rates are amongst the lowest interest rates in G10 space and indeed globally. Moreover, there is little chance that European central banks would attempt to match a Fed Funds rate of 0.5%. In other words, the Dollar would again become one of the primary funding currencies, potentially resulting in carry related Dollar selling. Obviously, this is currently unlikely, given balance sheet limitations for US banks, but in a scenario of reduced financial stress, Dollar funding would likely become more easily available again and this is the assumption.
• Given the US still has a sizable trade deficit and is in need of an additional demand boost from exports, it would make sense to see the Dollar on the cheap side of fair value - at least until it becomes clear that the trade deficit has narrowed further to sustainable levels.
• And indeed there is a risk of further widening of the trade deficit. Additional fiscal stimulus could leave the US in a twin deficit situation similar to the one in the 1980s.
• Rising oil prices on the back of slowing investment in additional crude production capacity could lead to higher oil prices at some stage, which potentially would put renewed pressure on the US trade deficit and hence the Dollar.
• Weak demand overseas could lead to sluggish exports and further headwinds for a narrowing of external deficits. Add to this the perception of longer-term structural problems in the US and foreign investors may be quite reluctant to invest in the US, leading to the continued BBoP deficits.

Near term outlook still Dollar bullish though

• With potential Dollar weakness kicking in at some stage, it is important to focus on the base from which this could occur. Given the near-term forces appear to remain very firmly skewed towards further strength, the Dollar may rally further before turning the corner.
• Dollar funding stresses remain present and deleveraging and asset disposal could continue in this current uncertain growth environment. As a result we would expect correlations between risky assets and major FX crosses to remain quite high. This in turn implies that the near-term Dollar outlook becomes somewhat conditional on equity and credit markets. Given a still tight financial conditions and a number of negative feedback loops linked to slowing investment and employment, market remains quite cautious on the outlook for risk assets and hence implicitly relatively bullish on the Dollar in the near term.
• The fiscal stimulus will likely be stronger in the US than in other major countries, in particular in Continental Europe. This will likely be supportive for the Dollar, all else equal, until fiscal consolidation kicks in.

While most observers have commented on the potential of further deleveraging in the near term, the more interesting and difficult question is probably the size, speed and timing of a subsequent Dollar weakening.