Having started the week by diving to lows last seen back in December of 2009, the US dollar closed the period out with a notable effort to reverse its fortunes. Friday’s performance was particularly remarkable for the currency as it was the biggest rally for the trade-weighted Dollar Index in two weeks. Having started the week by diving to lows last seen back in December of 2009, the US dollar closed the period out with a notable effort to reverse its fortunes. Friday’s performance was particularly remarkable for the currency as it was the biggest rally for the trade-weighted Dollar Index in two weeks. However, the significance of a sharp rally is diminished when it is initiated from 16-month lows. For the dollar to make serious headway moving forward, the currency has to gain real ground against its safe haven counterparts (the yen and Swiss franc), its most liquid complements (the euro and pound) and the high-yield faction (the Australian and New Zealand dollars). Such an outcome is difficult to accomplish through the dollar’s normal channels; but there may be a bigger shift just starting to take root that eventually spurs the currency to generate its own fundamental power. Taking stock of the winds that will carry us into the coming week, we should note that perhaps the most remarkable catalyst through the close of the week that passed was the indirect bids from euro and sterling selling. Considering much of pressure that has been leveraged against the greenback in preceding weeks was founded on this carry interest following ECB and BoE rate expectations; the subsequent correction in these trends naturally benefits the funding currency. In fact, it was this indirect flow that helped the dollar diverge from the S&P 500 which climbed for the third consecutive day and six of the past seven sessions through Friday. Heading into the new week, these contrasting drivers will struggle to keep the dollar buoyant. To develop this momentum, we will likely need to see a negative bearing on sentiment really build steam and subsequently undermine the strength of those currency that are backed by high rates or forecasts for near-term rate hikes. There is another scenario that benefits the dollar however – one that will likely take more time to really establish itself. The dollar’s malaise over the past couple years has been driven by rising earnings, recovery economic activity and carry interest all played against the greenback’s own low yield. And, while the market’s short attention span may not bend back that far, recent history tells us this is not a permanent characteristic for the currency. In fact, before the 2007/2008 financial crisis, the dollar maintained a substantial yield. Given the policy winds and economic trends, that first hike probably won’t come until the end of the year or early 2012; but this is a speculative market and expectations will start altering our course well before the actual move is made. And, we have had tangible evidence that the shift in actual policy has already begun this past week. The Fed’s decision to allow a number of TARP banks to once again release dividends, the Treasury’s announcement that it was selling toxic debt back to the market and a clear hawkish lean from policy officials this past Friday tell us the first steps have been taken. Related:Discuss the Dollar in the DailyFX Forum, John’s Pick: EURUSD a Factor of EU Fallout, AUDUSD a Reflection of Risk Euro: Don’t Write Off the EU Summit’s Impact, Sentiment will Suffer What happened with the EU Summit this past week? We were holding our collective breath to see whether policy officials would hammer out a meaningful accord on a number of touchy topics to solidify traders’ focus on interest rate expectations. Yet, the highlights and tentative results from this gathering were spotty and wholly unconvincing. In fact, it would be a fair assessment to say that financial stability had actually taken a step back after this meeting. The more controversial topics would see no meaningful resolution. The bond purchasing program gained no traction; the Irish Prime Minister would not budge on the nation’s corporate tax rate so neither would the group entertain lowering his emergency lending rate; and Portugal was deemed financially sound after the government was dissolved and suffered multiple downgrades. And, further adding to the mix, German Chancellor Angela Merkel demanded her country’s initial tab for the new EMS was too high. Despite this ultimately disappointing outcome, why then did the euro not drop off across the board? Some may say these are non-factors; but long-term stability, growth and yield potential are critical elements for trends – and that has certainly changed after this week. The shared currency was likely holding its bearings through the market’s continued preoccupation with interest rate expectations – which are still exceptionally. However, the foundation for this optimistic bearing has started to crumble. Should underlying risk appetite trends give way, the euro will not hold up well to scrutiny. Then again, perhaps we can see an additional catalyst that can drive uncertainty to concern. Poor (or otherwise dubious) results from the Bank of Ireland’s stress test of its financial system could be just the thing to do it. British Pound Reversal Brings Currency Back to its Critical Turning Point The British pound has gone from a currency on the verge of a major reversal against the US dollar, to 14 month highs, back down to its precarious position all in the span of seven trading days. The source of this volatility has been the backdrop for investor sentiment. The short-lived Japanese-borne financial crisis didn’t spur the pound to significantly losses; but the subsequent rebound in capital markets certainly appealed to FX traders waiting for the interest rate expectations to be realized. Yet, rates forecasts would also undermine the currency’s strength. This past week, the Bank of England once again played down excessive inflation and stole the wind from bulls’ sails. And, the warning from Moody’s that weak through could undermine the deficit cutting effort and thereby the nation’s sovereign rating. There is a lot of potential in the sterling for yield growth; but it needs an opportunity to realize that strength. Without it, confidence will be at constant risk. Canadian Dollar: What Does a Vote of No Confidence Mean for FX Traders? There were certainly bigger headlines globally; but Canada met the same political quandary that Portugal had last week. The main opposition Liberal party pushed through a vote of no-confidence to call the fourth election in seven years. This particular instability alone wouldn’t necessarily hurt the loonie; but coupled with a possible weak GDP reading next week or retracement in crude, it could produce real momentum. Gold Consolidating Again Just off Record Highs as Traders Await New Sentiment Trend Once again, gold is nudging record lows but failing to find meaningful follow through. This was the same general situation we faced in the first half of the month and the entire fourth quarter of last year. The recent volatility in capital markets should have helped fortify this safe haven and alternative store of wealth; but it also reminded us that investors need capital when conditions start to fray. This will be a unique one to follow.

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