US Dollar May Be Setting Stage for Advance

Fundamental Outlook for US Dollar: Bullish

-    US advance retail sales fell 1.5% in September, led by contraction in auto sales
-    Fed meeting minutes indicated that Bernanke & Co. were open to expanding MBS purchases in September
-    US inflation reports continue to give mixed signals, with headline CPI at -1.3% and core CPI at 1.5%

The US dollar was one of the weakest major currencies last week, with the Japanese yen beating the greenback to being the biggest loser, as market sentiment reflected increased risk appetite. This was probably best exemplified by the media’s euphoric response to the DJIA’s test of 10,000 on Wednesday and close above on Thursday, but with extreme optimism comes the risk of reversal.

Looking to the week ahead, US dollar event risk will start to pick up again on Tuesday as US housing starts and building permits are projected to have risen for the second straight month in September to 10-month highs, with starts anticipated to hit 610,000 from 598,000 while permits may rise to 590,000 from 580,000. While the unemployment rate is still in the process of rising, the federal government’s tax credit for first-time home buyers of up to $8,000 is likely to remain supportive of demand through the end of the year. However, if the program expires as planned on December 1, the growth we’ve started to see in the housing sector could start to wane.

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From Bloomberg

“World leaders are acting on threats to dump the dollar while the Obama administration shows a willingness to tolerate a weaker currency in an effort to boost exports and the economy as long as it doesn’t drive away the nation’s creditors. The diversification signals that the currency won’t rebound anytime soon after losing 10.3 percent on a trade-weighted basis the past six months, the biggest drop since 1991.”

“Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it,” said Steven Englander, a former Federal Reserve researcher who is now the chief U.S. currency strategist at Barclays in New York. “It looks like they are really backing away from the dollar.”

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“The conspicuous test of a 14-month low in the Dollar Index last week and the simultaneous push to a one-year high from the benchmark Dow Jones Industrial Average is certainly not a coincidence.”

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“The U.S. Federal Reserve is widely expected to hold borrowing costs at the record-low in September and is anticipated to maintain its $1.75T asset purchase program to encourage a sustainable recovery, and long-term expectations for higher interest rates may drive demands for the dollar as market participants speculate the central bank to tighten policy in 2010.”

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Investors are keenly awaiting clues on when the Fed might announce its plans for an “exit” from economic stimulus.

“We are still at the stage where discussions over the exit should not be confused as making preparations for the exit,” said Divyang Shah, of IFR Markets.

“The rally on risk assets should continue once financial markets are assured that policymakers are not going to prematurely kill off the recovery in economic and financial sentiment,” he added.

In line with a lessening of risk appetite, some of the most severe losses were for those currencies whose economies are most exposed to commodity prices.

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