FX Outlook: How the US Dollar Could Trade in Q4

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The lack of U.S. data today gives us the opportunity to take a step back and actively consider what could be in store for the U.S. dollar in the fourth quarter. The year has flown by quickly and after this week, the third quarter will officially come to an end. For most portfolio managers and professional investors, this means 2 more months of hard core trading before the volatility in the financial markets dry up due to the holidays. Not only will the U.S. Presidential Election be taking place in the fourth quarter, but the next few months will also be an important test of the effectiveness of central banks. 2012 has been a tough year for the U.S. dollar. The most significant losses occurred over the past 2 months and in that period alone, the dollar underperformed every major currency, dropping more than 6% against the euro. Yet, the price action in the FX market over the past week has many investors wondering whether the dollar is consolidating before a larger move lower or attempting to bottom. To answer this question, we take a look at the factors driving the dollar right now, the impact of central bank monetary policies and the 3 parts of the world that pose the greatest risks for the U.S. dollar in the fourth quarter.

Like it Or Not – Central Banks Take Credit for Driving Stocks Higher and Dollar Lower

Improving risk appetite is the main reason why the U.S. dollar performed so poorly over the last 2 months. While the U.S. economy is still in rough shape and Americans are only cautiously optimistic, U.S. stocks have performed extremely well. Last week the S&P 500 climbed to its highest level in 4 years, which is surprising because this hardly feels like a well-supported rally. Job growth in the U.S. has been anemic, consumer spending is stagnating, Europe is still a mess and China is slowing. True, corporate earnings have been better than expected but that doesn’t say much when companies have been lowering the bar. So why in the world are stocks rallying? The answer is simple – central banks and their persistent demand for government bonds. The Federal Reserve, European Central Bank, Bank of England and the Bank of Japan have been doing everything in their power to make government and corporate bonds unattractive to investors. With interest rates at record lows, the only place investors can turn to for yield and return are equities. Some investors moved into stocks early and others followed shortly thereafter as they look at what they can get from stocks versus bonds. While it can certainly be argued that the rally in stocks can’t last because of global headwinds, the abundance of liquidity from central banks is aimed at keeping the party going and we don’t recommend fighting central banks that are determined to keep their economies supported, especially if they are working together.

Don’t Fight Central Banks Especially If They Are Working Together

The goal of flooding the markets with liquidity is to inflate or reflate asset prices. Higher stocks and bond prices are exactly what central banks seek to achieve and yes by consequence, commodity prices may rise as well. What is significant about this month’s announcements from the Fed and ECB is that they have not only flooded the market with cheap money, but they also laid out a firm commitment to be a buyer of last resort AND to do more if the labor market weakens (in the case of the U.S.) or a country like Spain needs a bailout. In other words if stocks start falling sharply as a result of a significant downturn in the labor market or more trouble in the Eurozone, central banks are telling the market that they will do everything in their power to reverse sentiment. The Fed and ECB are not going at it alone – the Bank of Japan also increased asset purchases last week and the Bank of England is engaging in a Funding for Lending Scheme (FLS) which basically provides lower funding costs for banks with the hope that it will increase the quantity and lower the price of lending for businesses and households. Whether you think reflating asset prices is the right path to growth or not, higher asset prices is generally positive for risk appetite and negative for the U.S. dollar. While the greenback has recovered in the past weeks, if central banks keep on buying and equities keep on rising in Q4, the dollar should resume its slide.

Dollar Will Win the Race to the Bottom

We also believe that the dollar will win the race to the bottom. Central banks have gone pedal to the medal on monetary easing and aggressively eased monetary policy. Traditionally, monetary easing is negative for a country’s currency but with all 3 central banks moving at the same time, investors are wondering which currency will be the biggest loser and which central bank will win the race to debase. We think it will be U.S. dollar because the ECB’s program can’t be implemented until country formally requests for aid and the BoJ’s program is limited by size and timing. The Federal Reserve on the other hand expanded their asset purchase program immediately this month. So even though both central banks pledged to buy more bonds, the Fed is the only one of the two that has put money on table and this is why in the long run, we expect the dollar to underperform the euro. Also, at the end of the day, these initiatives by central banks will reduce default risk and overall risk premium. Since investors are still net short EUR/USD, the decline in risk should lead to more short covering in the EUR/USD.

3 Main Risks in the Fourth Quarter

As the fourth quarter nears, there are 3 main risks that could affect how the dollar trades.

#1 – U.S. November Elections Could Raise Concerns About U.S. Credit Rating

For the November elections it is less about the men running in the race and more about how the fiscal cliff is handled. Regardless of whether Barack Obama or Mitt Romney wins, the expiration date for tax cuts and automatic spending programs will be extended beyond December 31st. Given the highly partisan nature of the U.S. government, even if Obama is reelected unless he has a strong majority in Congress, there’s not enough time for a formal grand sweeping agreement to be reached. The current administration has battled over the best way to reduce the budget deficit for more than 2 years now with no agreements. When the elections are over, smaller deficit reduction measures will most likely be announced and then followed by a new deadline for tax cuts to expire in the first or second quarter. While this means that the issue of the fiscal cliff can be avoided for now – if Congress kicks the can down the road, it could raise concerns about the U.S. sovereign debt rating leading up to the November elections, which would be a problem for the U.S. dollar.

#2 – China Gears Up For Major Leadership Change, Could they Ease Immediately After?

China is gearing up for its most significant leadership change in more than a decade but they have been super secretive about when it will happen. We know that it will be at the 18th Party Congress, which should take place over the next 2 months, but Chinese leaders are struggling to determine the right time when in the past have given delegates at least a month’s notice. Seven out of the nine ruling members are scheduled to retire and it is not clear who exactly is in the running outside of the 2 officials set to replace President Hu Jintao and Premier Wen Jiabao. While many people believe that the leadership change won’t have a big impact on the financial markets because the party remains the same, there is one scenario that could. The Chinese government could choose to announce substantial monetary or fiscal easing after the leadership change (which will most likely be in October) to drive confidence in the new government. We know that the Chinese economy could certainly use it given the recent deterioration in data. More stimulus from China would be extremely positive for risk appetite and bearish for the U.S. dollar.

#3 – No Bailout for Spain and More Clashes at EU Summit Could Drive the Dollar Higher

While developments in the U.S. and China are expected to weaken the dollar, ongoing problems in Europe could maintain the attractiveness of the greenback. The possibility of a full Spanish sovereign bailout has not disappeared with the ECB’s unlimited bond buying program and after so much speculation, an application for a credit line from the European Financial Stability Fund (EFSF), which is a necessary step to activating the ECB’s buying program could actually be positive for the euro. However Spain refuses to bow down and ask for help and last week, both the Spanish and German government have denied Spain’s need for a European bailout. The longer that Spain holds out, the greater the concern about their fiscal performance which could ultimately renew risk aversion, sending investors back into the arms of the greenback. EU Leaders will also be holding 2 key summits in the fourth quarter – one in October and one in November. If heads of states do nothing but clash over near term crisis measures and the banking union, concerns about the future of the euro and the critical safety net for the banking sector could also drive the euro lower and the dollar higher.

Central bankers and economists around the world have made it clear that Europe poses the greatest risk to the financial markets. So even though there are plenty of reasons why the U.S. dollar should lose value in the fourth quarter, it only takes one fire in Europe to trigger a flight to quality and a rally in the U.S. dollar. However if the actions by central banks in September effectively eliminates the tail risk in the market and stabilizes sentiment, then the foundation has been laid for further weakness in the greenback. Dollar weakness is not a bad thing if it is driven by risk appetite – in fact, that’s exactly what we all hope to see in Q4.

Kathy Lien
Managing Director

5 thoughts on “FX Outlook: How the US Dollar Could Trade in Q4”

  1. Dollar weakness is very bad, very very bad, for everyone in the United States who isn’t interested in whether risk appetite is being fed, and who is attempting to survive under a roof instead of under a bridge or freeway. As a trader, I do understand what you are saying in the last sentence, though.

  2. Good summary. Agree that the preponderance of factors driving the dollar create a decidedly bearish outlook for Q4 and also for 2013.

  3. Not sure the USD will win the devaluation race by a wide margin. I do get the impression that as the biggest central banks have all announced more QE, they are probably also co-ordinating their currencies’ exchange rates so that they all lose value at approximately the same rate. That is, these currencies all remain within a broad range of each other.

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