The US dollar's performance over the next six months will largely have to do with the domestic economy, hinging on factors ranging from Federal Reserve policy, Presidential and Congressional elections, and a raft of US budget issues converging at year-end. Here are some of the main challenges in the US that market participants should keep an eye on in the coming six months:
Fed: More bond-swapping ahead
In the months ahead, market participants should keep a close eye on the US Federal Reserve and its quantitative easing efforts as the United States’ economic recovery continues to struggle.
Central banks usually strengthen the economy through lowering interest rates, but when times are bad and banks are reluctant to lend and borrowers to borrow, a low interest rate loses its simulative effect.
In those circumstances, central banks turn to what economists refer to as “quantitative easing’' or “QE” — a kind of guerrilla finance that involves pumping money into an economy and seeking to lower the long-term interest rates that central bankers do not usually control.
Fed’s chairman, Ben S. Bernanke has continued to affirm that the Fed has QE tools available that it can use to support the economy in case of weakness. Most recently, when economic data softened in the late spring, the central bank responded in June by extending a QE program called “Operation Twist,” in which the bank sold short-term bonds and bought long-term bonds.
The Fed has said it will continue to swap bonds over the next six months, but refrains from announcing QE3. The Fed began “Operation Twist’' in September 2011 with a pledge to swap $400 billion in securities. The extension announced in June will involve swapping bonds worth $267 billion more.
Presidential race 2012
In American politics, markets will be watching closely the presidential race as President Obama and the Democrats seek a second term against the Republican Party and its presumptive nominee, Mitt Romney in the upcoming November elections.
With the race largely focused on the economy, President Obama and Mr. Romney are traveling the country to deliver speeches designed to boost their appeal to the electorate, and diminish their opponent’s.
For instance, when it comes to the economy, Democrats say that Mitt Romney and the Republican case for more spending cuts versus tax revenue to address the nation’s fiscal woes is doomed for failure, citing the dismal effects of Europe’s austerity programming. Key talking points include highlights of Portugal, Italy, Greece and Spain either teetering on the edge or having already fallen off; Britain again in a recession, and the United States enduring a weak recovery due to government cuts.
However, President Obama has so far decided not to present the argument and take up this line of attack himself, in part because it would be unwise for him to do so as he attempts to persuade European leaders to dump austerity as they manage their financial crisis.
In attacking Mr. Obama’s stewardship of the economy, Mr. Romney’s campaign has stated that the president’s policies have made the recession “worse” and “last longer.” Yet, the bi-partisan Congressional Budget Office found that Obama’s stimulus package did in fact save and create jobs, lower unemployment and help the economy grow in the short term – a point that even conservatives who once said the policy was wasteful and poorly targeted now tend to acknowledge.
There is plenty of debate over how effective Mr. Obama’s economic policies have been, but economists do not generally claim that the president’s policies worsened the recession or made it longer. In a recent CNN poll of polls, President Obama leads as ‘Choice for President,’ by 48% to Mr. Romney’s 44%.
Pending just beyond the November election comes the prospect of what some are calling “Taxmaggedon,’' or what Ben S. Bernanke, the Federal Reserve chairman, has referred to as “a massive fiscal cliff.”
This is when, in the absence of Congressional agreement and action, all of the temporary tax cuts passed under the George W. Bush administration and extended by President Obama expire on Dec. 31 — an event that the Congressional Budget Office predicts would put the economy back into recession.
According to an analysis of the fiscal cliff by Moody’s Analytics, economic growth could slow by 3.6 percentage points in 2013, and some projections forecast a $700 billion blow to the economy should Democrats and Republicans not reach an agreement on the automatic tax and spending changes.
The severity and duration of the probable recession is difficult to predict, however, given the current fragile state of the economy, there is a strong likelihood that the contraction would be a challenge to reverse once initiated.
On the other hand, if Congress decided to repeal or delay all of the scheduled changes — in effect, extending the Bush-era tax policies indefinitely — there would be no progress toward long-term deficit reduction, raising the risk of fiscal crisis in the future.
Though, it is worth noting that the economy will not immediately dive into recession if Congress fails to reach a budget agreement before the new year because the recessionary impact of higher taxes and lower spending builds over time.
The challenge now is for lawmakers to foster economic recovery while, simultaneously, put the budget on a sustainable path. But election-year politics make a sensible budget agreement all but impossible anytime soon. Sure, an agreement will probably be reached, but only when it finally must - which is months away.
Recent releases of data signaling a slow-down in the global economic recovery and a lack of meaningful progress from policy makers has moved sentiment away from risk.
This has benefited the US dollar, with EUR/USD cracking ascending trendline support around the 1.26 mark last Thursday, and now holds scope to run to its 2012 low in the 1.2290 area; a break below there would leave room for the pair to test 1.2130, then 1.1940.
GBP/USD again slipped through the 1.56 barrier this week, and has since traded down into the 1.55 area. The pair is poised to test trendline support measured from the 23 Jan 2009/19 May 2010 troughs, around the 1.54 figure. Farther to the downside, GBP/USD may encounter buying interest at 1.5110 (Jan 2001 high), should it break the 1.52 mark.
Continued strength in the trade-weighted USD is anticipated in the months ahead on the back of persistent European funding stress, China’s sluggishness, the US’s fiscal cliff and slower global growth.