| The Economy and the Credit Market | |
| With the end of the year fast approaching, the market is making a review of the dollar through 2009 while speculators and the Fed are already plotting out their forecasts for the new year. Through much of this past year, the greenback was facing a brisk headwind from a fundamental and speculative standpoint. Not only was the currency throttled as global traders exited safe haven Treasuries and funded higher-yielding positions with cheap US financing; but the dollar was also facing the long-term prospect of losing its appeal as the world’s reserve currency. Looking at the greenback’s recent strength, there is little doubt that the effects of short-term swings in speculative sentiment have more than a little to do with the year-end reversal. After shorting the currency for approximately three-quarters of the year, it was inevitable that market participants would eventually unwind their speculative positions and book profit. However, it is not yet clear as to whether this is a bounce associated with year-end accounting and risk reduction or a true reversal founded on the combination of US fundamentals and a speculative qualification of an oversold currency. Relative growth and interest rate forecasts are improving; but that may not truly factor in until well into the first half of 2010. And, in the background, the world is slowly reducing its exposure to the US economy and currency. An IMF report today revealed the dollar’s prevalence in global reserves was at a 10-year low. |  |
| A Closer Look at Financial and Consumer Conditions | |
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| Heading into the new year, financial stability will be a prominent question for speculators, policy makers and the average citizen. On the one hand, the government is maintaining expansive stimulus programs (and in many cases it is still losing ground on encouraging a recovery). And, on the other, the Federal Reserve and Treasury are confident enough in the market’s stability that they are rolling back key emergency programs. Balancing the possibility of a double-dip recession against the threat of another bubble or hyperinflation is a delicate process. However, as we have seen with the 2007-2009 financial meltdown – today’s markets are global; and a shock can develop in any corner of the world. And, there are still plenty of active fault lines out there. | The past few weeks have offered a significant round of economic data to fill out speculation surrounding growth forecasts in the United States. There have been clear and tangible signs of improvement in housing sector sales, business activity, spending and income trends, and consumer confidence. And yet, this improvement can just as easily be chocked up to the economy climbing back up to a level of stabilization as it can be labeled a meaningful recovery. To qualify a true return to the strong periods of growth in economic activity and market values that have colored the past two decades; critical elements must fall into place. Among the most essential components are employment, consumer spending and long-term investment. |
| The Financial and Capital Markets | |
| We are heading into year-end trading conditions; and already the market is showing the effects. Thin liquidity and a prominent lack of a meaningful trend are defining investors favored asset classes (equities, fixed income and even currencies). It will some time for the market’s to fill back out; but when market depth does return, it will bring with it fundamental convictions. Over the past few months, underlying investor sentiment has more or less held unchanged. So, while the US dollar may have rallied and gold has reversed sharply from record highs; they have done so on the virtue of being an overbought or oversold in their own right, and not a reflection of a changing in risk appetite. Going forward, risk appetite will be essential to the trends that develop into 2010 and beyond. Revived bullishness can support speculative interests long enough to lure long-term capital back into the market and establish a sense of stability. On the other hand, if the turning of the dollar proves prophetic and general sentiment sours; one of the strongest advances in recent financial history may prove to be a mere bounce after a record-breaking slump. |  |
| A Closer Look at Market Conditions | |
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| Recent price action in the capital markets offers a clear lesson on the effects that thin liquidity can have on price action. For equities, profit taking and the absence of large sources of capital has led the Dow Jones Industrial Average to carve a range that is little more than 350 points. Of course, this trend hasn’t developed in just the past week; but rather it has defined the market’s course for nearly two months. This is a precarious position for investors’ favorite asset class. On the other hand, we have crude; which has been extraordinarily volatile, but which has ultimately moved little in three months time. Between the two, we can see where the greater potential is come 2010. | Measures of fear and risk are certainly skewed by the unusual conditions that have set in over the last few weeks of 2009. Looking at those indicators that are based on volatility, we see the effects of thin liquidity; but then again, it is also difficult to make an objective assessment of activity through stymied volume and open interest. In these types of conditions, we need to lengthen our horizons and look at the trends that have developed over the past month, three months and year. Risk – and the premiums that it entails – have dropped off significantly over the year. But looking back even further, risk is still high relative to the average levels of the past five to ten years and beyond. |
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at jkicklighter@dailyfx.com.
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