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The Economy and the Credit Market While the larger trend for the US dollar is still bullish; the potential for a permanent bearish reversal for the benchmark is higher now than it has been at any other time this year. Without doubt, much of the greenback’s strength has been born from a global demand for safety that has reinforced the demand for Treasuries and deeply liquid capital markets. However, the fundamental appeal of the region and its currency cannot be understated in this equation. A market-wide move towards risk aversion has only really developed over the past few months. That can be qualified by the reversal from the S&P 500 and other equity indexes around late April. Traditionally, these markets have a far more simplistic connection to underlying sentiment. With risk trends accounted for and an effort to pull the currency back from a relative extreme; where else did this strength come from? The outlook for interest rates and growth. Though it has been relegated to the background recently, economic activity and yield returns are essential to the risk/reward analysis that is performed for every trade – either subconsciously or by design. Now, with investor optimism leveling off, we can more clearly see the influence to that the more tangible fundamental trends have. Yet, recently we see that the housing market is struggling and interest rate hikes are a long ways off. Under these conditions, the dollar is fully dependent on a drop in risk appetite to revive its rally and keep that trajectory intact. |
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A Closer Look at Financial and Consumer Conditions
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| Though the speculative markets have cooled from their excessively high levels of volatility and pulled out of their nosedive, the stability of the underlying structure is under greater strain. The European Union continues to nurture a financial crisis with the market’s demanding ever higher yields to finance member nations’ deficits and public banks feeling the sting of the international investors’ cynicism. Currently, Greek 10-year note yields are above 10 percent; and Hungary, Spain and Portugal are paying rates that are unsustainable. If conditions do not materially improve soon; other nations will have to ask for EU help which will further depress confidence. On a positive note, the long-term outlook has improved with ambitious budget promises from the UK and Japan. | It may frustrate traders who are looking for meaningful shifts from each meeting; but the Fed’s consistency in its assessment of the US economy’s health is without doubt the best gauge for near-term performance. Along with the decision to hold the benchmark unchanged this week, the central bank would remark that the recovery is “proceeding” and the labor market is improving “gradually.” However, a cautious overtone and warnings of a negative financial health impact on activity paints the picture of a moderation in the pace of recovery going forward. For solid evidence that the world’s largest economy is not in a robust period of expansion, we have a round of housing data that adds to personal consumption’s under performance. New home sales are at a record low as stimulus gives way to true demand. |
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The Financial and Capital Markets Though many of the market’s financial benchmarks may have put in for dramatic rallies these past few weeks; in reality, the sentiment behind these speculative shifts is more akin to stabilization. The S&P 500 and Dow Jones Industrial Average have rallied approximately 8.5 percent partly on the condition that a failed attempt to catalyze a reversal into a bear trend would encourage an immediate relief rally. However, looking beyond the simple weathervane that equities play; we can actually see that the situation is much more complicated. In the currency market, the safe haven dollar has retraced only a fraction of its gains against the euro. At the same time, the 10-year Treasury note is still trading just below its highest level in 14 months. This divergence between asset class simply highlights the varying sensitivities to the speculative interests. Equities are far more susceptible to sharp bullish and bearish runs borne from the momentum of the market itself. In contrast, the dollar and Treasuries are more fundamentally rooted to the considerations of financial and economic uncertainties. Ultimately, it is the more stabile and controlled market that defines direction; while the more volatile and sensitive assets mark trading opportunities for sharp reversal.
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A Closer Look at Market Conditions
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| Measuring the performance of the capital markets this past week, it is clear that the good will from a speculative reversal has run thin. Now, we may need clear fundamental support to keep investor sentiments buoyant. The Dow has found a temporary ceiling in its fledgling rally after having retraced 50 percent of the April 26th to June 8th decline. Pushing any higher would require a good reason to invest in stock (an outlook for capital appreciation or perhaps dividends) rather than just momentum in a reversal. Commodities have been just as noncommittal in their upswing; but the climb from crude has shown a surprising level of stability. | Where are the signs of uncertainty? Well, beyond price action itself; we can seen investors’ doubts developing in areas that are more reflective of uncertainty rather than sheer reaction. Just under the surface, implied volatility (a measure of expected price movement priced into options) may have retraced from the multi-month highs developed during the most dramatic bouts of price action these past months; but they are still well above the levels seen over the past year. Digging even deeper, we see that US junk bond spreads are at 9-month highs, European government yield spreads are hitting record highs and corporate default premiums are inflating rapidly. Conditions are clearly deteriorating. |
Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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