Forex Investment and Currency Trading

Some market opinion is that monetary policy will remain one of the key factors for the Dollar and more aggressive QE by the Fed will weigh on the Dollar.

Given the initial imbalances were bigger in the US, that the pace of contraction in Q4 and Q1 was faster than in most other countries, and given that the Fed has a history of more activist monetary policy than most other central banks, a comparatively more accommodative stance by the Fed will likely remain in place. This is the core scenario for the next 6 to 12 months and generally reflected in a Dollar bearish stance across the FX forecasts.

There are a few questions marks regarding the impact of fiscal policy, as more proactive fiscal policy could partly offset the impact of more proactive monetary easing. However, the timing and impact on real demand of a fiscal boost is even more uncertain than the impact of QE. Many spending programs take a long time to get implemented and may become relevant only once the recovery is firmly established.

Dollar Funding in Improved Risk Environment
Few investors would consider a long EUR/$ position as a carry trade, despite German 1yr swap rates still about 50bp higher than the US equivalent.

However, when asked if they want to fund a basket of high yielding currencies in US$ or EUR, most would probably rather avoid the ECB given the continued reluctance to push policy rates too low and to engage in more aggressive QE. The Dollar will therefore likely again join the group of traditional funding currencies (JPY, CHF) as already in 2001-2004.

Possibly, the growing role as funding currency is among the main reasons why the Dollar continues to trade with a negative correlation to other risky assets. Even relatively short windows of 1 to 3 months suggest the negative correlation in returns between the S&P and the Dollar Index (DXY) remains close to record levels of about -30%.

Combining the status as funding currency with the broad improvement in the cyclical outlook, makes Dollar weakness increasingly a feature of the recovery theme. However, it is still likely that traditional funding currencies like the Yen or the CHF will weaken even more in this environment.

The moment the Fed withdraws the more abundantly provided liquidity, the Dollar will likely rally. Having eased more initially, it is clear the Fed will also have to tighten more. This could well coincide with a moment where fiscal stimulus provides the maximum boost to domestic demand in the US, which would lead to the very FX supportive mix of expansionary fiscal and tight monetary policy.

However, before we get to this Dollar bullish scenario, there is one key obstacle to circumnavigate. Given the extremely accommodative monetary policy currently, any perception of the Fed falling behind the curve could lead to a Dollar negative inflation scare. This would likely be temporary, but should the Fed be willing to accept initially rising inflation –to be totally sure about avoiding the bigger risk of deflation – the Dollar may well suffer until the Fed becomes more clearly hawkish.

Overall, further cyclically motivated gradual Dollar weakness is expected over the next 3 to 6 months, some stabilisation towards 12 months and clear risks towards renewed Dollar strength at some stage next year. A few funding currencies like the Yen have the potential to underperform the Dollar, but most other major currencies will likely outperform.