US Dollar Extends its Rally as Sentiment Threatens a True Collapse

US Dollar Extends its Rally as Sentiment Threatens a True Collapse
Investor sentiment is on the verge of collapse and the US dollar is reaping the rewards. The market’s most liquid currency put in for another aggressive rally; but it was perhaps today’s advance that held the greater influence from a fundamental stand point. The argument could be made that the greenback indeed produced a meaningful technical break yesterday; but without the support of risk aversion from across the speculative markets, the currency’s momentum would ultimately be limited. However, should risk appetite falter and traders be forced to unwind their high-yield, high-return positions; the repatriation flows to the US will proffer a considerable boost to the currency. Looking at the dramatic price action across the other major asset classes; it is clear that if sentiment hasn’t yet faltered, it soon will. Perhaps the best evidence we have for a wave of profit taking and position unwinding is the plunge from the Dow Jones Industrial Average. The benchmark broke a 300-point range for the first time in two months and quickly dropped below the 50-day moving average that has defined the market’s climb since July.

Despite today’s high level of volatility and the incredible correlation across the different asset classes; there is still a level of doubt in a true reversal of a trend that has defined speculative endeavors since the first quarter of the 2009. One obstacle is the positive bearings on growth that have been refreshed over the past 36 hours. In the Asian session, China released its fourth-quarter GDP figures to much fanfare. The government reported a 10.7 percent rate of annual expansion through the end of the year - the strongest pace since 2007. Adding to the mix, the World Bank just yesterday raised its 2010 growth forecasts for the global economy (2.7 percent) and the US (2.5 percent). Next week, the UK and US will release the advanced readings of their own fourth quarter performances. This will provide us with gauge of health for the industrialized world which is slower to recover. However, negative readings on growth readings aren’t necessary to turn risk appetite. The outlay of speculative capital and high level of the various markets denotes a market that is fundamentally overvalued. And, considering the recent moves made by policy officials, they are both concerned about another asset bubble and are looking for ways to deflate it. China has already taken several heavy-handed steps towards cooling its markets; and the United States seems to have joined the effort today. In a press conference, President Barack Obama announced proposals for both limiting the size and risk profiles of the nation’s banks. While such regulations would certainly reduce the risk of a future firm failure developing into a market-wide crisis; it will also limit speculative interests and turnover in the US.

Looking ahead to the final 24 hours of active trading this week; there are no key economic indicators on the docket. Though, given current market conditions; that does not mean the market will lack volatility. Forex traders will be looking to equities, bonds and commodities in addition to their own market to establish the market’s level of fear through correlations. If Friday ends with another significant down day, it will be exponentially more difficult to revive confidence.

Related: Discuss the US Dollar in the DailyFX Forum, Dollar Surges as Speculative Sentiments Sours, Rates Slowly Rise

British Pound Hit after Record Deficit Dims Currency’s Safe Haven Appeal
Recently, the British pound has found itself on both sides of the risk spectrum. The economy’s struggle to recover from its worst recession in decades coupled with its low benchmark lending rate has traded off with signs that a few key sectors were growing and inflation could force the rate issue for the Bank of England. However, any hope that the sterling would maintain speculative momentum from a fundamentally ‘oversold’ position during this seismic shift in underlying sentiment were dashed with today’s data. While the mortgage approvals, public sector borrowing and CBI quarterly factory activity figures were all offering relatively strong results; the focus was on the nation’s deficit. Last month, the United Kingdom’s budget gap ballooned to 15.7 billion pounds – the biggest short fall on records going back 1993. Chancellor of the Exchequer Alistair Darling said the effort to halve the deficit within four years was “non-negotiable,” but that leaves clear problems. Spending rose 7.5 percent in the month and the nation is still struggling to find its footing. Cutting expenditure could stifle a recovery – especially when the coffers are emptied by high unemployment and a severely depressed business sector. What’s more, Prime Minister Brown has to call an election by June; and it is difficult to tell what will be worse: desperate attempts at winning the popular vote or a regime change that reversals the successes to this point.

Related: Discuss the British Pound in the DailyFX Forum, British Pound Extends Decline as Budget Deficit Widens at Record Pace

Euro Suffers from Safety Flows, Disappointing Leading Growth Figures
The euro has seen its fundamental appeal slowly slip away over the past few weeks; and the recent downdraft in risk appetite has only amplified its struggles. First and foremost, the capital that was purposefully diversified away from the greenback to find a better balance of risk/reward is being reversed. While the efforts by central banks to better spread out their sovereign risk will be maintained; those market participants that are working for a profit are now looking for a safer harbor for their funds (and perhaps even a source of return). The appeal of safety is even more prominent considering the attention that Greece’s deficit continues to receive. Greek Finance Minister Papaconstantinou said today that the country doesn’t need an EU bailout; but doubts remain. To top it off, data released today reflected a cooling in some of the Euro Zone and German business sectors in January.

Japanese Yen Contends with the US Dollar for Top Funding Currency Status
While the Japanese yen has enjoyed the reversed capital flows of the past week; it is important to take an accurate assessment of its fundamental strength (especially when it comes to its value relative to the US dollar). There is no doubt a significant notional level of leveraged carry that was funded using Japanese yen and can be subsequently unwound. However, the currency is far from a safe haven. The future shows a struggle to establish an economic recovery, ongoing credit troubles and an extension of crippling deflation. When conditions stabilize, the yen will once again fall into the category of funding currency. And, when US market rates finally perk up; even USDJPY will climb on carry.

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Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com