The US Dollar $USD Index • NY Spot Close 9457.56

US Dollar Traders Have to Monitor Debt Talks, Euro Market, Risk Trends

Fundamental Forecast for the US Dollar: Neutral

• Dollar tumbles after EU attempts to put out its financial fires, ahead of major US event risk
• Credit rating agency Egan-Jones lowers the US top credit rating a step to AA-plus
• Dow JonesDollar Index (ticker = USDollar) extends its bearish-leaning consolidation

The countdown for the US is getting serious. We have concluded another weak where the US government has failed to come to a compromise on its deficit troubles. Further creating troubles for the greenback, we have seen the European funding market (a source of liquidity costs that plays to the dollar’s safe haven status) come into at least a temporary period of relief with a massive bailout effort by the EU; while risk appetite trends have taken a considerable jump to defer that long-threatened collapse. That said, all of these headwinds will do more to anchor the currency than necessarily generate a meaningful trend over the next week.

Heading into the new trading week, the deficit debate carries the greatest potential sway over the dollar. Depending on how this situation evolves; it could have a sweeping effect over the single currency and even the broader financial markets. Yet, it is prudent to work within reasonable probabilities to interpret how this matter will influence the dollar. If our outlook were for two weeks, it would be a virtual guarantee that the greenback is in for significant volatility and even a significant trend. However, our outlook is just for the upcoming week. That being the case, the outlook is far more fluid. Considering the deficit ceiling will be officially breached on August 2nd, there is time for political maneuvering as Democrats and Republicans gain points for sticking to their guns. It is a severely low probability that this situation ends in a technical default and the likelihood of a solution before next weekend is high.

How the deficit solution impacts the dollar and capital markets is a function of what is agreed to. If the limit is simply lifted to avoid the pain of a default event, it could offer temporary relief to capital markets and the greenback in equal parts. That said, the follow through would likely be limited as ratings agencies have warned the reasoning for a downgrade runs beyond just the quick fix and to the lack of long-term fiscal plan. Alternatively, should there be proposal that targets significant deficit reduction over a reasonable timeframe through a revenue (taxes) focus, an expenditure (spending) focus or a mix of both; it could be seen as an effort to pump the break on the economy and withdraw the very stimulus that has driven confidence and capital markets since the Great Recession – which would weigh on risk appetite which adds a safe haven appeal to the dollar as it garners attention for improved outlook for stability. If we end the week without a clear solution; expect volatility to grow increasingly unstable as rumors and headlines spur fear and speculation.

Another major driver for the dollar that fits within the ‘theme’ category is the blowback the greenback bears from the perception of the Euro Zone’s credit health. This past week, officials announced sweeping policy agendas to smother the sense of crisis contagion in the sovereign and private lending markets. There were major efforts adopted; but there are also significant shortfalls. Ultimately it comes down to market sentiment. If the steps taken don’t boost confidence or if risk aversion is an engrained and global driver, the euro will continue its slide and thereby boost its most liquid counterpart: the dollar.

When it comes down to it, these more pervasive and vague problems will determine the dollar’s activity level and general direction. However, there are a few scheduled events that can stir short-term volatility and perhaps even contribute or detract from existing trends. We have consumer confidence and housing sector data; but the real market-mover is the first reading of 2Q GDP. Depending on how risk trends are behaving, the outcome for the dollar can follow risk trends or speculation for additional stimulus. – JK