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What’s In Store for the US Dollar in 2012?

Last updated 12/26/2011 10:04 AM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

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At the beginning of 2011, we were feeling the initial winds of recovery. Non-farm payrolls were on the rise, reaching a high of 235k in February as the U.S. unemployment rate dipped to 8.8%. Even retail sales rose 1.3% that month, leading most market  strategists to believe that the worst of the global financial crisis was really behind us. Yet, as the year draws to a close, many traders feel cheated out of a recovery by Mother Nature (earthquakes, tsunamis, and floods) and politicians who mishandled fiscal policy. The U.S. dollar ends the year not far from where it started and after all of the volatility, the value of the greenback against the euro is virtually unchanged. The overall performance of the dollar was more mixed as the greenback strengthened significantly in the second half of the year against almost every major currency, wiping out earlier losses and even tacking on gains against certain currencies, such as the Australian, Canadian, and New Zealand dollars. The rally in the greenback had nothing to do with the strength of the U.S. economy and everything to do with the safety of U.S. Treasuries. Even after the U.S. lost its AAA rating, investors continued to buy dollars, which is a testament to the liquidity of the U.S. financial markets and the perceived safety of U.S. Treasuries. The safe-haven status of the greenback will be a characteristic that continues to determine the direction of the dollar in 2012.

What the Election Year Means for the Dollar

2012 is an election year in the U.S. but there may also be leadership changes in France, Russia, and Venezuela. The political change in some parts of the world will be more seamless than others; Putin is set to replace Medvedev as the president of Russia, Nicolas Sarkozy will be fighting to retain the French presidency, and elections in October could mean the end of Hugo Chavez’s regime. The most important and highest profile election will be in the United States where President Obama will be fighting to secure a second term. His approval ratings at the end of 2011 are well shy of where they need to be for him to win re-election. Yet, Obama could still win depending on how the economy performs over the next 10 months or whether the Republican candidate will prove to be a worthy adversary with a compelling message. For investors, the presidential battles in Washington and Paris mean that world leaders will be more focused on domestic developments than global cooperation. Unfortunately, this comes at a dangerous time when countries around the world need to help each other rise from the ashes. For the currency market, an inward focus could mean less global progress and more risk aversion/deleveraging/demand for safe havens like the U.S. dollar. Stocks usually perform well in election years: 2008 was different because of the financial crisis, but over the past five decades, stocks fell only four out of the 17 election years. Using the deutschmark as a proxy, we have data on the EUR/USD going back to the 1970s which covers nine election years. The currency pair weakened eight out of the nine years by an average of 6%. In other words, the dollar tends to perform well in election years, which will be important for traders to remember in 2012.

The Year of Global Stagnation

Unfortunately, 2012 will most likely be a year of global stagnation as we enter into the most significant collective fiscal tightening period in decades. Politicians around the world have pledged to curb spending and 2012 will be the year to deliver. In the U.S., fiscal tightening will intensify with unemployment benefits and payroll taxes set to expire. President Obama will look to extend these benefits, but it will be an uphill battle that will most likely result in watered-down measures. Political gridlock will paralyze the U.S. economy in the new year at a time when banks, households, and businesses reduce borrowing and lending. Over the past few years, we have endured quite a bit of volatility in the financial markets and the natural inclination for consumers and businesses is to cut back. Normally, recovery from a financial crisis is good for equities and currencies, but with more regulation and the trouble in Europe, less lending by U.S. banks means less financing for growth. American banks will also be reassessing and most likely reducing their overseas lending in the coming year; this is positive for the dollar. There will be more stability in the U.S. economy next year with the unemployment rate slowly falling, but growth will depend on whether politicians in the U.S. continue to make the right choices.  The U.S. will most likely avoid a recession, but growth is expected to be anemic at best. The OECD predicts that the U.S. economy will grow 2% in 2012, down from a prior forecast of 3.1% with most of the recovery weighted towards the second half of the year.

More Support from the Federal Reserve May Not Be All that Bad for the USD

The recovery is contingent on more stimulus from the Federal Reserve. Quantitative easing (QE1 and QE2) have avoided the return to recessionary conditions and stabilized the U.S. economy, which started to see some improvements towards the end of the year. Unfortunately, the strong possibility of recession in Europe and more volatility in the financial markets in the first few months of 2012 means that the Federal Reserve will need to increase stimulus. U.S. monetary officials are gearing up to boost transparency and are considering tying interest rates to inflation and/or unemployment. Beyond these measures, we also expect the Fed to increase their balance sheet by boosting asset purchases. QE3 may not be as bad for the dollar as QE1 and QE2, especially if it comes at a time when other central banks are also lowering interest rates and engaging in other unconventional measures to support their local economies. If Europe falls into recession (presently the chance of that happening is greater than 65%), the European Central Bank could cut rates aggressively, which would lend support to the greenback, even if the Fed increases their asset purchases.

Carry Trades – Not this Year

This will also not be the year for carry trades. Europe’s troubles are far from over and the first half of the year will most likely be marked by more uncertainty, deleveraging, and defensive positioning. This hurts more than it helps carry trades. Instead, the U.S. dollar could turn out to be one of the big winners, particularly in the first half of the year. For carry trades to work, we need to be in a low volatility environment where central banks are raising interest rates and investors are both optimistic and willing to take on risk. Unfortunately, 2012 will be marked by high volatility, more stimulus, and risk aversion, which means that rather than thriving, carry trades could end up underperforming significantly in 2012.

What are the Risks to Our Outlook?

The main risk to our outlook is that Europe comes up with a rescue plan quickly enough to avoid recession. All of the tensions in the global markets have been caused by the problems in Europe; if European leaders can put their personal agendas aside, open their pocketbooks, and be more lenient about the EU Treaty, the crisis could be resolved. This will be a challenge, but one that is surmountable. In fact, we would be delighted if our pessimistic outlook for the global economy was completely wrong and 2012 becomes a year of strong recovery because that means better times for everyone. Unfortunately, when it comes to politics, nothing is ever easy and the fate of the euro and European Monetary Union overall lies in the hands of politicians. If the recession is limited to Europe and the U.S. enjoys a stronger recovery, safe haven flows could ease out of the U.S. dollar, but even then, austerity measures will erode growth.

Year for the Dollar

2012 should be a year where the U.S. dollar performs extremely well. Like 2011, the strength of the dollar will not come from strength in the U.S. economy, but rather from more deleveraging and uncertainty. Even though the U.S. economy is expected to grow, for most people, it will still feel like stagnation that borders on recessionary conditions at times. If President Obama fails to get the payroll tax and unemployment benefits extended, growth in the U.S. will be even weaker and his chance of re-election slimmer. Political uncertainty is not usually positive for a country’s currency, but in the case of the U.S. dollar, the uncertainty could drive more investors into the safety of U.S. Treasuries, keeping the greenback supported in the process.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.