2012 Forecast: USD to Strengthen Further in First Half of 2012

The US dollar is expected to outperform other major currencies in the first half of 2012. The key reasons for the greenback's glitter are the ongoing sovereign debt crisis in the Eurozone and the relatively strong economic improvement in the US. It is, however, rather difficult to forecast the outlook of the US dollar in the second half of the year as uncertainties related to the pace of recovery in European economies, fiscal tightening in the US and the FED's implementation of QE3 heighten. Moreover, the ability for China to avoid hard landing would be another factor affect USD's outlook.

The US dollar index gained +1.46% in 2011. Among the major currencies under our coverage, USD rose again EUR (+3.23%), GBP (+0.41%), CHF (+0.44%), NZD (+0.09%) and CAD (+2.77%). We expect the greenback to continue to shine in 2012 and, again, rise against the euro, with gains mainly realizing in the first half of the year. Sovereign debt problems in the Eurozone will deteriorate further in 2012 and only a situation worse than the current one would push policymakers to work more seriously on fiscal consolidation. It's likely that the 17-nation region will fall into recession this year as driven by weakness in confidence, fiscal problems, bank deleveraging and slowdown in the global environment. The situation in the Eurozone would hurt market sentiment and risk aversion would lead to buying of USD which is considered as a safe-haven asset despite fiscal problems in the US itself.

In light of domestic economic deterioration, the ECB is expected to accelerate monetary easing and lower interest rates to levels lower than what have been currently priced in. On the other hand, the better-than-expected economic indicators released in the US in the last quarter of 2011 should keep the Fed on hold for some time. The spread of interest rates between the US and the Eurozone creates another reason for USD purchases.

Let's take a look at the US economy. After a slow start in the US economy in the first half of 2011, growth has accelerated in the second half of the year. Employment and manufacturing data in 4Q11 signaled that US economic conditions have stabilized at low growth rate but non-recessionary levels. The Congress passed extensions of payroll tax cuts and unemployment benefits before its expiry on December 2011. These measures are expected to support the growth picture. Inflation will remain low as unemployment is still high and spare capacity in the economy remains significant. These are likely to keep housing prices stagnant and wage low.

In September, the Fed announced to perform operation twist - to increase in the duration of its balance sheet by selling $400B of short-term maturities and buying the same amount in longer-term maturities. In addition, the central bank stated to keep interest rates near zero at least until mid-2013. Given recent improvements in economic outlook and low inflation, the Fed will likely not extend asset purchases in coming months. However, this is not to say that the central bank would be refrained from QE3 for the rest of the year. A spillover of the Eurozone crisis would hurt the US economy and weaken the job market further. In this case, the Fed may need to accelerate asset buying to stimulate growth. The move would be negative for the US dollar.

Source: Action Forex