3 Ways the Dollar Could Go in Q4

09/26/2012 7:00 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

Kathy Lien explains what could happen in global markets to help or hurt the greenback significantly in what promises to be an eventful fourth quarter.

A quiet start to my week gives me the opportunity to take a step back and actively consider what could be in store for the US 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 two more months of hardcore trading before the volatility in the financial markets dries up due to the holidays.

Not only will the US 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 US dollar. The most significant losses occurred over the past two 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 three parts of the world that pose the greatest risks for the dollar in the fourth quarter.

Like it or Not...Central Banks Take Credit
Improving risk appetite is the main reason why the US dollar performed so poorly over the last two months. While the US economy is still in rough shape and Americans are only cautiously optimistic, US stocks have performed extremely well.

Last week, the S&P 500 climbed to its highest level in four years, which is surprising because this hardly feels like a well-supported rally. Job growth in the US 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 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.

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

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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 US) 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 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 US 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.

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 three major 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 the US dollar, because the ECB’s program can’t be implemented until a 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 the Fed and ECB pledged to buy more bonds, the Fed is the only one that has put money on the 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.

Next: Three main risks that could affect how the dollar trades.

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

No. 1: Elections Could Raise Concerns About US 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 31.

Given the highly partisan nature of the US government, even if Obama is reelected—unless he has a strong majority in Congress—there’s not enough time for a grand, sweeping formal agreement to be reached. The current administration has battled over the best way to reduce the budget deficit for more than two years now, with no agreements.

When the elections are over, smaller deficit-reduction measures will most likely be announced, 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 US sovereign debt rating leading up to the November elections, which would be a problem for the US dollar.

No. 2: China Gears Up For Major Leadership Change
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 two months, but Chinese leaders are struggling to determine the right time, when in the past they 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 two 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 up 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 US dollar.

No. 3: More Clashes at EU Summit Could Drive the Dollar Higher
While developments in the US 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. After so much speculation, an application for a credit line from the European Financial Stability Fund (EFSF)— 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 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 two 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 US 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 US 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 is a frequent speaker at the Traders Expo and a trader at BK Asset Management.

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