Dollar Would be the Primary Benefactor of Volatility or a Market-Wide Risk Reversal Next Week

The benchmark dollar has plenty of event risk over the coming week; but compared to some of the highlights on other dockets, its listings are far from critical. Even so, the greenback will remain at the center of any momentous changes in the FX market derived from underlying shifts in speculative expectations thanks to its principle role as the world’s most liquid currency and begrudgingly-accepted safe haven status. Taking stock of the pressure that has built up behind the capital markets in general; we find many pairs and assets closed this past Friday’s trading session on the verge of trend-defining reversals. Acting as the benchmark for the majors, EURUSD closed just above a well-worn pivot see at 1.35. If sentiment is at risk, then the threat of reversal on a nine-month bull trend for the yield-heavy AUDUSD and NZDUSD should come as little surprise. Yet, giving greater credence to the dollar’s own intrinsic strength; the safe-haven balanced USDJPY and USDCHF pairs are both standing at the threshold of another phase of its February rally. What decides whether this is a short-lived live FX-based correction or a true speculative reversal, though, is complicity from the other asset classes. The 10-year Treasury note looks ready to rebound from nine-month lows, the S&P 500 is well-passed overbought and even gold is looking dangerously speculative. What we need is a catalyst and conviction.

If we want a genuine and pervasive transformation in the backdrop for speculative appetites, the tipping point will most likely be a deterioration in confidence in Europe’s financial conditions, concern that China’s inflation fight will panic global speculators or that the Bank of England’s austerity experiment will prove an disastrous example to the rest of the world. Compared to these looming threats, the dollar’s qualities are relatively benign and its positive characteristics require outside encouragement. That said, the docket will offer a thorough update on the economy’s progress towards recovery. Retail sales, housing starts, industrial production and capital flows are all critical to economic performance. The CPI data will play a unique role in shaping expectations for the eventual rate hike, and potentially before that, the withdrawal of the economy’s record stimulus.

And, though there is a dense round of predictable event risk ahead of us to threaten a near-term drive in risk appetite trends; we should also keep perspective of those fundamental developments that are further down the road. Though largely overlooked on Friday, the Treasury released a report offering up the proposal to wind down Freddie Mac and Fannie Mae. Essentially inevitable, there are far deeper connotations to this eventual effort than just exit of a stopgap for future disruptions in the housing market. These two GSEs hold a tremendous amount of toxic mortgage-backed debt that the market seems to have believed simply disappeared after the worst of the financial crisis. When market participants start to speculate on the influence of this transfer of assets back to the public space, the effects could be crippling.