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As Q4 dawns, USD is expected to remain under persistent, moderate downward pressure. There are risks that could prompt short bouts of USD buying, but the overall weight of evidence suggests that USD will feel heavy into year-end 2009, only stabilizing in mid-2010 as markets begin to anticipate Federal Reserve rate hikes.

Ahead of the October 3 G7 Finance Minister’s meeting in Istanbul, US Treasury Secretary Geithner said “a strong dollar is very important to this country, I mean that, and it’s very important that people recognize it.” Whether he was trying to convince global markets or himself is unclear, but European officials greeted the tepid USD support warmly. Markets have been less enthused, particularly after the G7 communiqué largely rehashed prior views, seemingly hardly worth the effort of writing or reading. USD (DXY index) has traded in a range of 75.9 to 77.5 since mid-September, and though there are some factors that could prompt a short-term rally, USD seems set to remain under persistent downward pressure for several months. Rallies will prove hollow. The pressure does not seem set to abate until mid-2010, at which point USD will stabilize. The prospects of an outright recovery at that point remain debatable.

Four key factors will affect USD’s underlying tone: 1) the stance of US monetary policy, 2) global imbalances, and the health of the global recovery as stimulus fades, 3) the short and long-term US fiscal situation, 4) the potential for a significant equity market correction and/or another bout of global financial stress.

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At present, the market is priced for the Fed to remain on hold for the next six months or longer, which will hang on USD, particularly as attention turns toward currencies of central banks likely to follow the RBA’s example and hike sooner rather than later. Even so, the debate about the timing of Federal Reserve rate hikes and exit strategies is becoming more active. There was much attention on recent comments by Fed Governor Warsh, particularly his speech on September 25
and an accompanying Op-ed piece. In the speech he noted that “policy might need to be unwound with the resolve equal to that in the accommodation phase,” suggesting the potential for an aggressive tightening campaign. However, that statement was qualified by the preamble “if the economy were to turn up smartly and durably.” A pre-condition for an aggressive rate hike campaign is an economy clearly and firmly on the path toward improving health. There seems little in recent US data to suggest that the economy has turned up smartly or durably, though it is clear the recession is abating.

As evidence accumulates on the pace of the US recovery, the debate over the timing of Fed action will deepen and would bolster USD. At present, however, a key prop of the US economy, the consumer, is notably lame, particularly after the September payrolls report and the benchmark revision that showed that the job tally was 824K too high in the 12 months to March. The foundations for a sustainable rebound, absent aggressive fiscal stimulus, are lacking. That said, Warsh did correctly note that policymakers should not wait until the “level of real activity has plainly and substantially returned to normal” as in doing so “will almost certainly have waited too long.” At present, however, it is far too early to worry about institutional credibility. Accordingly, it seems reasonable to take the FOMC at their word that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Hence, USD looks poised to remain under downward pressure in coming months.

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USD continues to remain closely linked with equity markets, such that a sharp downturn in equities could prompt USD buying. Thus far evidence of a market correction is weak. The S&P 500 is off its peak of 1080, but it remains above 1000. Globally, Asian and Eastern European stock market indices might have peaked, but Latin American stocks continue to perform well. It would take a more definitive, broad-based outbreak of risk aversion to prompt USD gains. However, the recent trend toward risk seeking has proved resilient and has kept USD rallies short and shallow.

A development that could prompt a USD rally, and an equity market correction, would be another bout of intense systemic stress. At present, however, signs of systemic stress are ebbing, as some of the initiatives introduced with much fanfare last year to deal with the shortfall in USD liquidity are beginning to be unwound. The swap lines between the Fed and foreign central banks to provide access to USD liquidity have also declined. An outbreak of risk aversion or systemic stress would be USD bullish, but another flight to safety similar to late last year seems unlikely, given that policymakers have been intensely focused on rebuilding the global financial architecture for the past year.