With global economic recovery seemingly in place and several central banks now focused on possible exit strategies from their unconventional ultra accommodative monetary  policies, the dollar’s fate is now depended on the direction of US short term interest rates. As we’ve recently noted , the dollar, not the yen has become the dominant funding currency in the carry trade due to the fact that US 3 month LIBOR rates are now lower than those of Japan. 

From a practical standpoint that means the greenback is now subject to massive selling pressure anytime risk appetite picks up, as carry is highly correlated to rising equity prices. Therefore the question facing the market is whether the Fed will abandon its quasi-ZIRP monetary policy any time soon.

Given the greenback recent weakness, the vote from the currency market appears to be a resounding NO. Despite some improvement in  US economic data there is a myriad of reasons for Fed remaining stationary for the next twelve months. First and foremost amongst them is the continuing deterioration in the labor markets. Although weekly jobless claims have receded from their 600K+ rate set earlier in the  year , they remain stubbornly high at around 550K level and will not signal an improvement in labor conditions until they drop below the 500K barrier.  Meanwhile the Fed will not even entertain the idea of raising rates until Non-Farm payrolls turn positive and even then may wait a full quarter to confirm the fact that the pick up in demand  is genuine. Dr. Bernanke is a world respected scholar on the Great Depression and is well familiar with the disastrous monetary policy decisions made at that time that exacerbated the contraction by raising rates too early in the recovery cycle.      

Additionally, the Fed’s balance sheet which is now full of illiquid and highly suspect financial assets may make it more difficult to initiate an exit strategy anytime soon while at the same time limiting any further expansion which in turn could temper economic growth going forward.  As a result of these dynamics, the near ZIRP like conditions are likely to remain in place for the foreseeable future. The Fed itself has stated flatly that interest rates will remain low for a very long time with St Louis Governor James Bullard noting that , “I don't think markets have really digested what that means."

Overall if this pattern holds true it should prove to be dollar negative as long as equity markets continue to rally. At this point other central banks do not even need to raise their rates in order for the dollar carry trade to prevail. Given the low interest environment the current spread between US rates and those of high-yielders such as Australia and New Zealand will support further dollar carry trade flows if equities are able hold on to their recent gains. Therefore, the dollar has now become the new yen and will be even more closely correlated with risk appetite as ZIRP conditions persist.