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The Economy and the Credit Market After a brief reprieve, the dollar continued its month-long decline this past week. The selling pressure behind the world’s most liquid currency is a coming from both speculative and fundamental sources. What is interesting is that the mix for influence is starting to even out and perhaps even tip in favor of the later dynamic. Up until a few weeks ago, the greenback was running on sentiment alone. Through April and May, the dollar was performing particularly well thanks to a drop in speculative interests and assets across the board – though it is worth noting that the currency had advanced since December on this particular element, it just so happened that the not every major pair was responding to the subtle shift early in the year. Today, sentiment has eased off as a prominent driver; and market participants have actually jumped on the balance in forecasts for the global markets to force a rebound to work off some of the bearish premium built up over the first six months of the year. Naturally, this ‘climb in optimism’ diminishes the value of a safe haven that is prized for liquidity and stability rather than return. A much greater burden for the dollar now and going forward is the deteriorating growth and interest rate forecast for the US. Expectations of a cooler pace of expansion and a deferred return to a hawkish policy regime were already priced in. However, with today’s FOMC minutes lowering the official GDP forecasts and warning of a possibility for deflation, the weak outlook is turning bleak. |
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A Closer Look at Financial and Consumer Conditions
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| It is important to make the connections between economic health and financial stability. Even in the best of times, when output cools, credit and investment trends decline. What happens then when growth eases when the system is already strained? We may soon find out. We have seen a clear deterioration in timely economic data these past weeks as a global effort to withdrawal stimulus has been accelerated by the adoption of austerity measures as concern swings from growth to sovereign credit health. The most palpable risk to the world’s financial markets is still the Euro region. Portugal has been downgraded and Spanish banks are being forced to borrow massive amounts of liquidity from the ECB. Next to give will most likely be China’s overdrawn lending. | The economic outlook for the world’s largest economy is less than impressive. While the general consensus among policy makers and economists for the medium term has generally pointed to moderation; it was rather clear that speculative interests were aiming much higher. With each disappointing economic release; reality further sets in. This past week, the country’s trade deficit ballooned to an 18-month high, retail sales fell a greater-than-expected 0.5 percent and the NFIB Small Business Optimism survey for June retreated from a 20-month high. This may seem a random assortment of data, but it covers vital areas of the economy. Confirming that activity is indeed slowing, the Fed’s minutes lowered its 2010 and 2011 GDP projections (to 3.0 from 3.5 percent and to 3.5 from 4.2 percent respectively). |
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The Financial and Capital Markets Despite the clear projection for economic activity to cool over the coming months and the threat of financial instability through European default or sovereign downgrades, the capital markets continue to climb. Is this a sign of risk appetite? Yes and no. There is an obvious investment in growth-based assets as evidenced by the appreciation in the market’s benchmarks. On the other hand, there is a difference between trading and investment capital. The former is looking for a momentum behind capital appreciation to make a quick profit. The more stable and lasting flows come from investment sources looking to make yield over time. Given the lack of fundamental support behind the climb in price, it is reasonable to expect that there is a heavy speculative interest in this drive that could withdrawal its support just as quickly as it was added. As the markets continue their climb, it is worth nothing that traditional volatility gauges (measuring implied volatility) have dropped off. This is a precarious situation as it reflects a sort of blissful ignorance whereby the resulting reversal sparks a sharp response. With a clear sensitivity to the trends in global finances and economic activity, the continued rise grows increasingly risky. The Chinese GDP reading this week and EU Stress Test due on the 23rd could realign speculation to reality in the near future.
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A Closer Look at Market Conditions
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| It is easy to point to the various benchmarks for the capital markets and say we are in a bull trend. Indeed, the Dow Jones Industrial Average has climbed for six consecutive days and covered nearly seven percent in that span of time. However, when we look at the bigger picture, we see that this upswing has developed directly after plunging a nine-month low and it still fits within a serious of lower lows that have developed since the April peak. Lower highs and lower lows is generally considered an objective sign that a market is trending lower. What is absent though in this development is momentum one way or the other. Is this permanent? | Looking beyond the limited information that short-term price action can relay (as it is prone to its own momentum), we see the signs of strain on an enduring recovery in investor sentiment. The most readily available evidence that risk is on the horizon is the quality of the economic data that has crossed the wires over the past few weeks. However, if that is considered too abstract for the speculative ilk, we can further look into premiums and positioning. Showing regional stress, we see yields are rising on European debt as demand wanes as concern over the economy’s solvency grows. And, looking at risk closer to the ground, benchmark three-month Libor rates continue their climb to new heights. |
Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com
DailyFX provides forex news on the economic reports and political events that influence the currency market.
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