We are entering the heart of Q3, so this is a good time to review the USD’s prospect for the rest of the summer.
The ongoing situation in the EZ is suspected to have major influence on the currency’s strength.
EU pain helps USD gain Shortly after the Spain bank bailout was announced, most pundits were thrilled; however, we warned that markets would soon realize that nothing had actually changed.
In particular, we noted that it’s unclear how the EUR can avoid continued weakness, for the following reasons:
1. The GIIPS are unlikely to avoid default without Germany and other funding nations agreeing to accept responsibility for GIIPS debts.
2. There is a need for a well-run “US of Europe” with a fully empowered central bank and enforced rules of responsible economic management. Only this might convince funding nations that a repetition of the current crisis can be avoided.
3. Even if all EZ members were ready to cede the sovereignty needed to do this (ceding control over budgets, taxation, borrowing and all kinds of banking and other financial regulation), they don’t appear to have the time or money to complete a process that could easily take 5-10 years or more.
4. Greece has missed about 70% of the requirements set out in the last bailout, so in theory it should not be eligible for more cash. That means it will default in a matter of weeks.
5. It is unlikely that Spain or Italy will be able to avoid needing a bailout in the coming years. Currently, the EU bailout funds are woefully underfunded for even one such sovereign bailout.
6. There is currently no source of interim funding to prevent defaults while the “US of Europe” is forming.
Given the above, the EU is providing an ongoing dual support for the USD.
Firstly, a weak Euro automatically pushes the USD higher. Secondly, the risk that a worsening EU crisis or wave of sovereign and banking defaults, combined with a global slowdown, benefits safe haven assets like the USD.
Quantitative easing 3 unlikely in Q3
We believe the Fed will refrain from significant new stimulus plans that could hurt the USD in Q3. These include:
1. The Fed doesn’t want to add new stimulus unless things get very bad in the US, in order to avoid the appearance of helping President Obama’s re-election.
2. Further effectiveness of more stimulus is unclear. Fed chairmen, Ben Bernanke, told Congress that he believes a better way to prop up the economy would be for Congress to defer the scheduled impending tax increases and spending cuts (aka “the fiscal cliff”).
Global central bank limits damage of QE 3 to USD
With virtually all major central banks in neutral or easing mode, even if new stimulus comes, the USD might not suffer much.
In sum, there is limited downside to the USD, though it’s vulnerable to short term pullbacks.
Further gains are likely if the EU continues its slide.