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DailyFX Home / Forex Market News / Weekly Columns / Watch What the Fed Watches

Dollar in a Holding Pattern as the Market Awaits September Fed Meeting

By , Chief Currency Strategist
31 August 2011 22:46 GMT

Be sure to join DailyFX Analysts in discussing their outlook for the Fed and its impact on the dollar in the DailyFX Forex Forum

Credit Market

Previous

Current

Change

% Change

Outlook *

DJ Credit Default Swaps

124.955

118.082

-6.873

-5.50%

Improving

10 Year Junk-Bond Spread

125.465

118.04

-7.425

-5.92%

Improving

Credit Card Delinquencies

3

2.91

-0.09

-0.09%

Improving

Mortgage Delinquencies

8.32

8.44

0.12

0.12%

Deteriorating

US 3 Month Libor Rate

0.312

0.327

0.01544

4.95%

Improving

Total Money Market Funds

2671.57

2629.18

-42.39

-1.59%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

11320.71

11646.42

325.71

2.88%

Improving

Dow Jones Real Estate Index

212.89

221.12

8.23

3.87%

Improving

Dow Jones Financial Index

318.94

331.64

12.7

3.98%

Improving

Dow Jones Retail Index

88.64

92.13

3.49

3.94%

Improving

S&P Volatility

35.9

30.92

-4.98

-4.98%

Improving

Put-Call Ratio

1.78

1.84

0.06

0.06%

Deteriorating

Market Breadth (Adv - Dec)

0.6972

0.2072

-0.4900

-49.00%

Deteriorating

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

1

1

1.00%

Improving

Mortgage Applications

-2.4

-9.6

-9.6

-9.60%

Deteriorating

Initial Jobless Claims

422

417

-5

-1.18%

Improving

Consumer Confidence (UMich)

59.2

44.5

-14.7

-24.83%

Deteriorating

ISM Manufacturing

55.3

50.9

-4.4

-7.96%

Deteriorating

ISM Services

53.3

52.7

-0.6

-1.13%

Deteriorating

ISM Services - Employment

54.1

52.5

-1.6

-2.96%

Deteriorating

An Improving outlook means the Federal Reserve coulduse thisindicator

to support a rate hike. The opposite stands for a deteriorating outlook.

The Economy and the Dollar

Dollar_in_a_Holding_Pattern_as_the_Market_Awaits_September_Fed_Meeting_body_Picture_1.png, Dollar in a Holding Pattern as the Market Awaits September Fed Meeting

A lot has happened for the dollar over the past few weeks. We have swung from a severe bearish to an extreme bullish outlook only to settle back into the malaise that had plagued the benchmark for so long before volatility kicked in. Before we were facing the US downgrade, the sharp capital market declines, the flare up in European financial troubles or speculation that Fed Chairman Bernanke would develop a tradition of major announcements at the Jackson Hole conference; the dollar was drifting as the markets looked for clarity on longer-term fundamental themes. As it happens, through the dramatic reversal in fortunes (from no guidance whatsoever to a glut of conflicting catalysts) the trend for the greenback has been consistently confused. If there were no dominant theme to sidetrack the dollar through short periods, the currency would naturally depreciate under the weight of exceptionally low rates, ballooned stimulus efforts, slowing growth and the enduring effort to diversify reserves. Yet, there are more pressing concerns to keep FX traders engaged. And adding a further level of frustration to these diversions, they are steeped in ambiguity. Keeping the bearish contingent around are expectations that QE3 could still be in the works come September 21 at the FOMC’s next policy decision. Yet, the extent to which this consideration is priced in and how much it could be expected to do for capital markets is being balanced by the threat of a global descent into economic and financial trouble.

A Closer Look at Financial and Consumer Conditions

Dollar_in_a_Holding_Pattern_as_the_Market_Awaits_September_Fed_Meeting_body_Picture_10.png, Dollar in a Holding Pattern as the Market Awaits September Fed Meeting

The threat of immediate, global financial crisis seems to ebb and flow like the tide. Just a few weeks ago, headlines were dominated by suggestions that funding troubles in the US and core European Union economies could escalate the market crunch and lead to a repeat of 2008. However, those fears simply receded with optimistic turns from policymakers (where rosy forecasts are essentially a job requirement) and the settling of the wholesale effort to unwind risky positioning. That said, a cooling in speculative interest does not equate to improvement in the state of underlying fundamentals. Risk aversion is a permanent fixture for the near-term and so is the momentum behind the economic slowdown. The next catalyst would be a liquidity and funding crisis.

Dollar_in_a_Holding_Pattern_as_the_Market_Awaits_September_Fed_Meeting_body_Picture_7.png, Dollar in a Holding Pattern as the Market Awaits September Fed Meeting

According to the minutes from the last FOMC meeting and various policy officials’ comments these past weeks, the economic outlook for the United States is fading. This isn’t particularly surprising given the monthly data we have seen and the trouble with translated stimulus into jobs; but the policy official admission gives us something to mull over. If central bankers are concerned that economic activity will stall (and potentially contract) despite their efforts; there is a greater probability that they will look to act again to try once again to jump start activity. For the capital markets, this effort is roughly translated into QE3 speculation; and the two-day policy meeting next month offers the forum to drive these expectations. In the meantime, we have NFPs on Friday to remind us what speed the US economy is running at.

The Financial and Capital Markets

Dollar_in_a_Holding_Pattern_as_the_Market_Awaits_September_Fed_Meeting_body_Picture_4.png, Dollar in a Holding Pattern as the Market Awaits September Fed Meeting

When volatility is extreme, trends and consolidation are under constant risk of reversal and breakout. Over the past few months, we have seen the capital markets transition through multiple phases of both activity level and direction. Yet, through the all the back and forth; the most prominent feature for the markets was volatility. The market-wide risk unwinding effort that took over at the end of July and beginning of August finally aligned the convictions of those expecting an economic decline and European-led financial crunch with those looking at a mild slowing in activity and reason for policy makers to step in to support markets once again. It is hard to hold to convictions of capital gains-boosting stimulus when markets are under intense selling pressure and delivering tangible losses. This was a long-overdue effort to unwind excessive leverage built on temporary stimulus. Yet, the pullback on the S&P 500 and other speculative assets was not sufficient enough to bring us to a natural level for the markets. The reconciliation effort has hit a common roadblock in renewed threats of further stimulus. It was believed that the Fed Chairman Bernanke would announce something akin to QE3 at his Jackson Hole speech; but his deferment wouldn’t spark disappointment. Instead, he bought time by insinuating the topic was just being carried forward a month. Now policy officials need to determine whether the repercussions of moral hazard and leverage on stimulus are significant enough to offset ongoing liquidity help.

A Closer Look at Market Conditions

Dollar_in_a_Holding_Pattern_as_the_Market_Awaits_September_Fed_Meeting_body_Picture_16.png, Dollar in a Holding Pattern as the Market Awaits September Fed Meeting

Looking at the performance of capital markets, we can still see the ravages of volatility. The S&P 500 Index is a particularly poignant example of what leveraged activity levels can do with a 270 point plunge in the span of a few weeks, a 65-point plus range for four consecutive trading days and then an uneasy rebound back up toward 1,220 (140 points from its August low). This is what we should be focused on more than the transient winds for direction. As long as volatility is exceptionally high and investors are extremely sensitive to financial headlines, it will be relatively easy to draw the markets into big runs.

Dollar_in_a_Holding_Pattern_as_the_Market_Awaits_September_Fed_Meeting_body_Picture_13.png, Dollar in a Holding Pattern as the Market Awaits September Fed Meeting

Most of the traditional volatility indicators have an inherent directional bias. As such, though the activity level behind the markets are still exceptional; the pull up from the aggressive selloff from the opening weeks of August has curbed the VIX and other options-based readings. To move beyond this shortfall, we should look at measures of market-liquidity, premium for duration and the excess cost for riskier assets. For this mix we can follow swap spreads, the yield curve and credit default swaps (or junk bond spreads) respectively. The yield curve will be particularly interesting as one of the options the Fed is entertaining for its next policy meeting is increasing the average maturity of its Fed balance sheet assets.

Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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31 August 2011 22:46 GMT