Dollar Finds Little Support from Data, Fed Conviction or Risk Trends

The dollar’s weakness over the past two months should come as little surprise to those that follow fundamental trends. There are three general fundamental elements that the benchmark currency typically follows when seeking direction and conviction: relative growth; interest rate speculation and risk appetite trends. It so happens that all three factors are working against the greenback at the moment. Over the past week, economic factors have been particularly critical in guiding the dollar. This past Friday, the advanced reading of the United State’s 2Q GDP reading came in under already tepid forecasts. Yet, it should be said that a cooling in economic activity has been expected from the speculative and official sides of the market; so this isn’t necessarily a surprise. This is important; because a similar curb in output by the nation’s primary counterparts (the focus is now on next week’s Euro Zone growth reading) could quickly balance out the greenback’s weakness. Another potential fundamental catalyst due this Friday is July’s nonfarm payrolls (NFP) report. This labor indicator is often treated as a proxy for underlying economic activity; so a notable improvement or contraction could have a significant impact on the dollar. That being said, expectations for employment are modest at this point given the number of jobs needed to offset the losses of 2007 to 2009. Finally, there is the greenback’s status as a safe haven – a diminished trait as of late. This past week, the S&P 500 has climbed to new highs. However, uncertainty surrounding China is starting to pick up where fear over a European crisis left off. If we had to choose the top catalyst, it would be risk trends.

Once again, an improvement in asset valuation seems to dull the market’s concern of underlying cracks in the financial system. This past week, it seems that the threat of a systemic shock has receded. However, there are many more threats to stability than the stability of the European financial system (the favored catalyst for risk over the past months). A growing threat to global investors is potential troubles in China. While it may seem this market and economy are isolated from the rest of the world, this particular nation in fact stands as the symbol of all that is bullish. That being said, news leaked today that the primary Chinese banking regulator has called on lenders to account for a worst case scenario whereby home prices drop 60 percent leaves us with a new reality to deal with.

Fundamentals have been shaky for the US economy over the past week. The big economic indicator for the period was the advanced reading of 2Q GDP. Economic activity slowed to a 2.4 percent annual pace of growth – modestly weaker than expected and a shadow of the 3.7 percent performance of the previous quarter. However, we have to consider that a slowdown in the US (and indeed world) economy was fully expected. To garner a better sense of performance, we are left to assess the performance of more timely indicators. Personal income and spending had both stalled, extending the disappointment in the weak personal consumption figure for last quarter. There was a little confidence to be garnered from the improvement in the employment and activity readings for the service sector though.

Given the performance of the capital markets over the past week, it would seem that investor sentiment is clear. The S&P 500 has breached an important resistance, crude has rallied above $80 and high-yield currencies have climbed. Yet, despite all of this, we are still left with a hesitant market. Looking beyond mere price action, we can reflect on actual capital flows themselves. Capital flows from mutual funds have maintained their persistent current, the risk inherent in benchmark libor rates continues to climb, safe havens that are divorced from systemic threats (like gold) continue to rise, and the capital market benchmarks have not actually made the shift from broad congestion to true bull trend. A large part of the market’s strength to this point can be traced back to speculators efforts to buy into a self-sustained bull trend to make a quick return. Stability and consistency, however, fall to investors that are looking to make a return over time and will not abandon their positions at the first sign of trouble. When will shift from speculative to investment interest come? It may not happen at all in this cycle should one of the largest global players suffer from a withdrawal of confidence ala Greece. It is still a long way to go before these markets post new highs for the year.

The benchmark capital markets extended their run this past week as the hope of return drew more speculators into the advance. The commodity market was the standout performer with the CRB index driving to a new multi-month high. This strength can largely be attributed to oil which would enjoy the speculative catalyst that a break of the $80 mark would imbue upon the market. The rise of the equities market is far less encouraging. While the favored indexes hit new highs, they would immediately lose strength immediately after crossing the technical threshold. The longer it takes to encourage real follow through, the less likely it is to actually develop.

A rise in asset prices doesn’t have to follow a decline in risk (a significant boost in potential return can effectively shift the scales); but many assume one must follow the other. In the past week, we have certainly seen a decline in the risk associated to an imminent default in European sovereign and high-yield market debt. That being said, these instruments end up acting as speculative assets in their own right rather than a meaningful indicator of actual risk. For a true reflection of health, we can look to readings of capital flows, bank-level lending rates and the level of demand for true safe haven assets. The withdrawal of capital from mutual funds, rise in Euribor rates and feigned effort to carry equities higher paint a picture.