US Dollar: The Threat of Volatility is Building Beyond the Holiday Period

http://www.dailyfx.com/forex/fundamental/forecast/weekly/usd/2010/12/24/US_Dollar_The_Threat_of_Volatility_is_Building_Beyond_the_Holiday_Period.html

US Dollar: The Threat of Volatility is Building Beyond the Holiday Period

Fundamental Forecast for the US Dollar: Neutral

• The signs of a dramatic turn in underlying risk appetite trends promise high volatility for the dollar
• Dollar’s outlook mixed against the majors as candlestick formations turn to congestion

The dollar ended this past week little changed on a trade-weighted basis. However, in this assessment, we are seeing heavy influences of EURUSD in the calculation of the Dollar Index. The market’s most liquid assets are prone to defaulting to stable trading conditions when speculative liquidity dries up because the necessary capital flows will overwhelm the highly volatile efforts of traders. In fact, if we look at most of the other majors (GBPUSD, USDJPY, USDCHF, AUDUSD, etc) we see that activity was surprisingly high for holiday trading conditions. This observation should be carried forward as evidence that the greenback is still exposed to bouts of volatility and perhaps even a nascent trend next week.

If we were to assess the probability that the dollar would be encouraged to a major trend (bullish or bearish, it doesn’t matter) next week; the results would be very low. Not only is the expectation of tamed trends a self-fulfilling prophecy; but there is also a very real lack of participation to carry trends forward when liquidity is thin. Now, this is not to mean that the FX market is all-of-a-sudden as thinly traded as a mid-level stock. However, to actually keep a currency pair as liquid as EURUSD moving requires a considerable and concerted effort to buy or sell the pair by many market participants. That said, FX is only one asset class in a range of securities that banks and other largest market players trade. Without capital flowing into and out of government bonds, developed equities, emerging markets, commodities, munis and other assets; the pressure on exchange rates via global financial flows will be significantly reduced. That said, the outlook for next week is anchored to the extended holiday weekend (many markets will be closed through Tuesday) and the influence of the New Years. Yet there is a lingering risk of volatility.

In the past month, the threat to global economic activity and financial market health has perceptibly deteriorated. Not only is the US looking at slower growth and restrained levels of return for the foreseeable future; but other countries are being pushed towards recessions and potential asset bubbles. In Europe, the long-term implications of excessive dependence on stimulus and lack of access to the markets for capital threatens to push some members into interim recessions while others seem to see little way out aside from a debt restructuring. In China, the threat of an asset bubble has grown quite real with the government moving to drain liquidity from the system – but ultimately failing to curb the extreme levels of leverage already built into the system. The instances of economic and financial imbalance along with an overdependence on temporary government stimulus are wide-spread. And yet, through it all, the S&P 500 has climbed consistently since the beginning of September to levels last seen before the Lehman Brothers collapse. It is difficult to reconcile a lack of participation in this advance in risky assets (US funds in equity funds have dropped for 33 straight weeks according to ICI and insider selling has consistently outpaced buying) with the steady advance in these benchmarks. Capital infusions by central banks and governments are clearly going directly into the capital markets rather than the more fundamental areas of the economy; and this misallocation will soon be reconciled. Seeing such a correction play out next week is unrealistic; but next month will represent a new trading year to assess. – JK

DailyFX provides forex news on the economic reports and political events that influence the currency market.
Learn currency trading with a free practice account and charts from FXCM.