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With so much attention justifiably focused on the EU sovereign debt and banking crisis, it’s worth taking break from Europe and considering the USD’s prospects for 2012.

THE GOOD

Here are the factors favoring a higher USD.

Dovish Fed Policy May Actually Aid USD Prospects

With this week’s super-dovish FOMC statement, The USD begins 2012 on a distinct down note, as forex markets anticipate continued low rates, and possibly a full blown QE 3 replacing the current “light” version. While the extended period of low rates and stimulus programs has not brought inflation, it raises inflation risks and so pressures the USD.

While the heightened threat of more stimulus has pressured the USD recently, we suggest that this development may contribute towards a stronger USD as the year progresses. With expectations already low for rate increases and high for more stimulus, expectations for the USD on these fronts are more likely to move in favor of the greenback, especially if the US economy performs relatively well and so reduces the likelihood of new stimulus coming. Indeed, the White House will be doing all it can to help the US economy over the coming year.

Moreover, as we note below, most other major central banks are also in easing mode, so the USD’s may not look any worse than its fellow majors from this perspective.

Global Stagnation Bullish for the USD

If, as predicted by many, US growth is relatively good (though lower than previously hoped) compared to that of the rest of the developed world, then the coming year could be bullish for the USD.

Bad Times Favor The USD

Economic downturns favor safe haven currencies like the USD. This downturn may be particularly favorable for the greenback because the central banks behind the other two traditional safety currencies, the JPY and CHF, have become more aggressive in devaluing their currencies. This is especially true for the CHF, which over the past year went from being the most stable safe haven to being the most heavily managed one. The SNB remains committed to keeping the CHF down relative to the EUR.

It Means Most Central Banks Also In Easing Mode

Also, dovish Fed policy may not be as damaging to USD prices as it has been in prior years, because in 2012 the Fed is no longer alone among the major banks in attempting to expand the monetary supply. The ECB, PBOC, BoE, RBA and BoC among others have all followed the Fed towards more dovish policies.

In other words, the continued dovishness of the Fed may not harm the USD’s relative position vs. the other major currencies at all.

It Means Declining Carry Trade

Carry trading is when you sell of low yielding currencies to fund purchases of higher yielding currencies, and profit on the difference. For example, you buy the AUD/JPY, you buy the AUD which yields 4.5%/year, and sell or borrow the JPY pay out its 0.10% rate, profit on the rate differential as long as you hold the position. This works well as long as the JPY or other funding currency doesn’t gain value vs. the AUD or other currency that you bought. If it does, your interest rates gains can be wiped out fast.

As I discuss at length in my coming book, The Sensible Guide To Forex, carry trades work best in times of rising growth and interest rates that favor the higher yielding risk currencies, not during times of recession when safe haven currencies like the JPY or USD tend to appreciate and thus make carry trades unprofitable.

In other words, times of stagnation mean reduced carry trade, and that’s another reason for increased demand for safety currencies like the USD.

Effects of the US Election Year on the USD: Historically Positive for the USD

President Obama’s approval ratings at the end of 2011 are well below what’s needed to win re-election.

The quality of both the US economy’s performance and his opponent’s campaign will determine whether he can overcome his current standing.

We expect President Obama will, like any politician up for re-election, attempt as much stimulus as possible in order to have the voters feeling as optimistic as possible as they go to vote in November 2012.

For this reason, stocks and other risk assets usually perform well in election years: 2008 was different because of the financial crisis, but over the past five decades, stocks have declined in only four out of the past 17 election years. Using the deutschmark as a rough proxy for the EUR, we have data on the EUR/USD from the 1970s to now, 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. That alone is important for traders to keep in 2012.

The Bleak Outlook for the EU Favors The USD

The ongoing crisis in the EU continues to keep markets nervous and thus ready to flee into the relative safety of the USD. It has better long term economic fundamentals than those of the JPY, and the CHF is now linked to the EUR. Together these factors make the USD the most attractive safe haven currency. Moreover, the EU crisis threatens to drive the EUR down further. As I’ve often noted in prior articles, because the USD and EUR are the most widely held currencies, they tend to push each other in opposite directions. So further declines in the EUR are bullish for the USD

THE BAD

Here are the factors that could pull the USD lower.

EU Crisis Stabilizes or Improves

Nothing in the past years suggests that it will be solved, but the EU leadership may yet again manage do muddle through. As noted above, a rising EUR virtually insures a falling USD. We don’t think this scenario is likely but it’s certainly possible.

US Politics Undermines US Dollar

Even without the pressure to hand out goodies to voters that comes in an election year, Congress was been unable to make serious progress in reducing its deficit during 2011. Thus we risk further credit downgrades on the Federal, as well as state and local levels.

Fed Goes All In for QE 3

If the Fed really opens up the money taps relative to its fellow central banks, then that would be a double negative for the USD:

  • It would drive down USD demand from the added future inflation risk.
  • In addition, QE programs are considered good for risk assets like stocks and risk currencies, and bearish for safe haven currencies like the USD

The Ugly

The most likely ugly scenario is a wave of defaults in the EU. While many claim that a Greek default is priced in, we don’t buy that, as we apply the “no such thing as one cockroach” theory. By itself a Greek default isn’t a disaster. The problem is that it will drive borrowing costs for the other GIIPS out of range risks starting an avalanche of sovereign and/or bank defaults from the banks holding those bonds.

In that kind of panic scenario, the USD should do very well, at least in the short term. Beyond that there are too many factors to make a useful prediction. On one hand the USD is a safe haven asset that should benefit in crisis conditions. On the other hand that same crisis is likely to reach the US directly or indirectly and ultimately undermine the US economy and with It the USD.

A less likely but still quite possible black swan event is an escalation in tensions with Iran that could send energy prices soaring. In all but the scariest scenarios that’s likely to be bearish for the USD as energy prices spike. However that’s a separate topic for another article.

Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.

Source: U.S. Dollar Forecast: What Everyone Needs To Know