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USD - HIGH ON DUBAI? Dubai & USD Implications

The Dubai Crisis – The Answer to USD Bulls’ Prayers?
 
 
As discussed in our last article The Must-Know Connection Between Stocks and the USD, the USD moves in the opposite direction of stocks, especially the bellwether S&P 500 index, and other risk assets
 
What’s Needed for a USD Rally
 
We have long said that for a USD reversal, look for one or more of the following must occur:
 
1.            A sustained period of at least consolidation if not reversal in global stocks and other risk assets that drives up demand for safe haven currencies as carry trades unwind. The S&P 500 has twice backed off from the 1100 level. Failure to break through soon could lead to at least a consolidation period if not outright reversal.
2.            A fundamental improvement in the US economy that brings recovery in the critical jobs, banking, and housing areas, quite possibly in that order, that provides reason for markets to believe USD interest rates will rise sooner than currently expected and thus lift the dollar out of its current status as a prime funding currency for carry trades.
3.            A selloff in the EUR, because for every 3 Euros bought, a USD is sold, thus any selloff on one automatically helps the other. Since March, this relationship has been a key driver of the EUR's rally.
The first possibility is the most likely, but as yet stocks have made only modest pullbacks, the second and third have not happened. In sum, there is still no major reason to buy dollars unless risk appetite turns into nausea and dollar shorts unwind.
  
It is possible that the Dubai crisis, if not quickly resolved, combined with fundamental weaknesses in the global risk asset rally since March, may bring about the first of these, which we’ve long argued is the most likely one to halt the USD slide.
 
Dubai Sigh – The Fear Catalyst
 
Contagion Fear – Fear that this is the start of a wave of other sovereign defaults. Government debt is traditionally considered among the safest asset classes, though developing world debt was always somewhat less so. This means rising fear, which sparks unwinding of forex carry trades, which in turn means repurchasing the US dollars sold to fund it
 
Fear for the Banking System: It’s currently unclear how much pressure this crisis will exert on the already stressed world banking system. Remember, the current global financial crisis began when default threats in the US housing market started to hit the US and international banking system. In other words, the banks led us into this crisis (also the past few in the US), and they have yet to regain the health needed to lead us out.
 
Developing world credit risk will be seen as higher, meaning developing world assets will be priced lower. This could mean pressure on many stock markets worldwide.
 
Developed world credit risk: Banks in Europe and the US with exposure to Dubai and any other falling dominos will come under additional pressure. Many are already under suspicion of being undercapitalized.
 
Conclusion
 
Given the weak underlying fundamentals of the March rally in stocks and other risk assets, this rally has been ripe for a pullback.  There are plenty of potential crisis waiting in the wings (residential and commercial debt, etc) If the Dubai crisis is not resolved quickly, it could well provide the fear and downward risk asset momentum needed for the long awaited pullback.
 
If that comes, dollar bulls will have reason to smile.
 
FYI: So will yen and Swiss Franc bulls, as well as the US Treasury.
 
DISCLOSURE: NO USD FOREX POSITIONS, BUT MOST OF AUTHORS ASSSETS ARE USD DENOMINATED