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The Fed Slowly Trims Stimulus but the Dollar is still Caught up in Risk

The dollar was on the decline after the FOMC’s rate decision today; but was this a direct reflection of the event itself or merely a sign that FX traders’ interests lie elsewhere? Considering risk appetite was on the rise before the central bank’s announcement was released, it is safe to say that the currency was still taking its cues from underlying market sentiment (where the dollar is relegated to its status as a safe haven and therefore funding currency). This is the resistance the world’s most liquid asset must overcome should we expect it to determine its own path in the future.

 

The Economy and the Credit Market

The dollar was on the decline after the FOMC’s rate decision today; but was this a direct reflection of the event itself or merely a sign that FX traders’ interests lie elsewhere? Considering risk appetite was on the rise before the central bank’s announcement was released, it is safe to say that the currency was still taking its cues from underlying market sentiment (where the dollar is relegated to its status as a safe haven and therefore funding currency). This is the resistance the world’s most liquid asset must overcome should we expect it to determine its own path in the future. One of two things can happen in the short-term to alter the greenback’s fortunes: either market-wide optimism will falter and boost its safe haven appeal; or the beleaguered currency will make a meaningful break from its place at the bottom of the risk spectrum. For timing, risk appetite is the more flexible and volatile dynamic; so a meaningful correction in the speculatively-driven rally of the past eight months is the more likely catalyst for dollar advancement. Yet, we should not write off the measured changes to its role in the market. The Fed announced today that it was reducing its agency-debt purchasing program from $200 billion to approximately $175 billion. This joins the end of the Treasury purchases, banks paying off their bailout loans and tests for withdrawing cash from the system through the money markets as a decisive step towards easing stimulus and coming closer to a hawkish policy stance.

 

A Closer Look at Financial and Consumer Conditions
Financial uncertainty has lessened according to the Fed’s statement today; but there are still notable threatens to its normal functioning. From the credit markets, defaults are still on the rise, banks are still failing at a relatively consistent pace and efforts to pad reserves has stymied lending to consumers and smaller businesses. Perhaps the most pressing concern for those tracking the health of the financial markets is the stability of commercial real estate. It is important to realize that despite what section of the market we are looking at, stability and growth is dependent on bullish markets where assets are appreciating. Should this steady rise in optimism falter, more losses will have to be realized and liquidity will immediately thin out.	Is the world’s largest economy going to have to adjust to a ‘new normal’ or will a stable and lasting recovery merely be catalyzed by different sectors? This is a debate not only of composition for future growth but one that ultimately defines what kind of recovery will see over the coming year and beyond. Over the past weeks and months, we have seen remarkable strength in both manufacturing and exports. However, compared to consumer spending, which accounts for approximately 70 to 80 percent of output for the world’s largest economy, these two streams of income hardly make up for the loss. In its assessment of economic activity, the Fed said activity will likely be “weak for a time.” This time frame could be truncated by a turn in jobs.

 

The Financial and Capital Markets

The development of a serious correction in the capital markets and underlying sentiment was stalled this week by a round of modestly enticing economic data and a steady stream of investment capital finding its way from the sidelines. It still stands however that speculative interests and tangible fundamentals are still incredibly running on very different paths. All that would be needed is a meaningful pullback to trigger a round of profit taking and subsequently develop a full-blown correction. What can encourage investment flows to fight the current? The removal of the market’s safety net. Back in the early months of the year, there was little yield to be made and risks were still plentiful. What encouraged confidence for speculators to transfer their funds from the safe harbor of their money market accounts and Treasuries? The guarantee from the government that they would step in to contain volatility and prevent another crisis. However, what we have seen over the past few months is that even though the Federal Reserve isn’t tightening monetary policy, it is quite clearly removing stimulus and backstops. This could cause a revolt in sentiment on its own or it could merely feed a reversal that develops on its own.

 

A Closer Look at Market Conditions
The capital markets have tentatively curbed a two-week pullback that was the most extensive that we have seen since the beginning of July. However, ‘curbed’ does not mean that the promulgation of bearish concerns has come to an end. While gold has been driven to a fresh record on surprise and temporary factors; other benchmarks like the Dow and crude have not made meaningful attempts to reverse the course that has investors growing more doubtful. We will likely find a definitive direction within the forthcoming week. Should these proxies for their respective asset classes establish new short-term lows or highs, speculation will simply take over from there.	Risk in the financial markets is particularly high for the coming week. Sentiment is not so robust that it can simply cast off pending event risk; and there is plenty of data to unsettle the markets. Interest rate decisions from the ECB and BoE can effect broader sentiment levels but Friday’s NFPs will have a direct impact on the US markets (which will in turn filter into underlying risk appetite). The volatility gauges for the S&P 500 and currency market have both surged to four-month highs. What’s more credit default premiums have risen significantly over the past two months. This reaction to an otherwise moderate pullback in underlying price action is a sign of the instability of speculation.

Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at jkicklighter@dailyfx.com.

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