Dollar Rallies as Fed Sparks Risk Aversion to Offset Weak Rate Outlook

We are at a possible inflection point for the US dollar. For the past two months, the single currency has tumbled as the promise in relative growth, expectations for higher rates and demand for a safe haven have all diminished. Everything that had leveraged the value of the greenback through the first six months of the year (a move that was itself a reversal of the market-wide bull wave of 2009) has been folded into the market’s valuation of the currency and its fundamental backdrop. And now, investors await the next meaningful shift in the balance that is so delicately maintained. This past week, both growth and interest rate expectations were burdened by unfavorable develops. For economic activity, the focus was on the non-farm payrolls report for July. As a proxy for consumer spending – and thereby overall growth – the indicator’s larger than expected headline drop was another bearish hit that adds to the discouraging turn that the second quarter GDP reading from a few weeks ago instigated. Though there is little room to further depress interest rate expectations, the FOMC managed it. At the conclusion of its monetary policy meeting, the group announced it was leaving the benchmark lending rate at a range between zero and 0.25 percent. What really struck the market though was the fact that they had also decided to halt efforts to drain excess stimulus by reinvesting money into Treasuries. This certainly defers the return to hawkish policy; but it also has the undesired side effect of furthering uncertainty in the health of the US economy and financial markets. And, investor fear is a benefactor of the dollar.

Confidence in the world’s financial markets is starting to unravel from different various locations around the world. Europe is once again in the news as hints from the Spanish Prime Minister that he is considering rolling back austerity measures and Slovakia’s vote not to support the Greek bailout show the region is not united in its effort to improve the Union’s image within the global community. However, Europe may not even be the biggest concern going forward. China’s banking regulator is apparently requiring its lenders to bring off-balance-sheet liabilities onto its books – a move that could immediately take the wind out of the economies sales. And, then there is the US. The threat of a stalled economy and a lack of flexibility with stimulus could lead to failure.

The economic bearings on the US economy have further deteriorated this past week. From the docket, the US employment data has maintained its weak pace; but it seems market participants are paying more attention to the stagnation. A focus on the weak growth in full-time employment is founding the masses in the reality that a genuine recovery towards full employment will require remarkable monthly additions that would be considered unfeasible even during a robust period of growth. Adding an objective tone to the economic outlook, the Federal Reserve would lower its assessment of economic activity going forward with the remarks that the recovery had moderated and would likely be weaker than anticipated in the near term. Tomorrow’s retail spending and sentiment data will help confirm.

There are times when the capital markets can weather even the most threatening economic and exogenous developments. That is just the nature of speculative interests. However, in the times that the market is focused on the uncertainty in economic activity and/or financial stability, even modest developments can drive assets lower. In recent days, we have seen the latter scenario take over. The responsibility for the current wave of market fear can be jointly attributed to the potential of collapse in a Chinese asset bubble, revived fear over a European default and the growing burden of debt across the global economy. However, the spark for this most recent bout of selling falls to the Federal Reserve. The central bank has not encouraged much volatility for the market in some time; because the policy reins have been left wide open for some time now. That being said, a significant contribution to the 2009 rally was the bank’s decision to flood the market with stimulus that would act as a safety net for investors through liquidity. Interestingly enough, at the most recent policy decision, the central bank would take a step to put a floor under its stimulus program; and yet, the market would respond with a sharp selloff? Why the difference? Stimulus is temporary; and its existence speaks of uncertainty; while a lack of flexibility points to limited effectiveness.

After two months of steady appreciation, the favored benchmarks for risk appetite have turned sharply lower in just a few days. True to the notion that this is a sentiment move, we have seen a tightened correlation across otherwise unique asset classes; and they are all moving at a hearty clip. Representing the greatest mass of retail investors, the equity market is led by the Dow Jones Industrial Average’s steepest decline since June (during a period that the market would drop 1,000 points and 9 percent). However, the true performer was the fundamentally-tuned EURUSD currency pair. Wednesday’s drop was the sharpest since October of 2008.

We have seen investor enthusiasm deteriorate long before the more popular gauges for risk and volatility began to correct. This week, the aggressive selling across the various growth-dependant asset classes has led to a significant response from the derivative risk indicators (volatility indexes, default swaps, etc). However, to truly assess the persistence of this trend and the breadth of the gap between expectations and reality; we can look to those indicators of capital flow that are true reflections of uncertainty. Among the more interesting figures, we see that the spread between the two and 10-year US Treasuries has dropped sharply as traders seek liquidity and the Euro and US three-month Libor rate spread hit a five month low.