special reports

How long can the dollar’s rally last? That is the question circulating in fundamental circles across the market. With risk aversion hitting a new level today, it is clear that the currency’s safe haven status is easily trumping all other considerations. However, where does the greenback stand if volatility settles and the market is no longer vying for the safety inherent in deeply liquid US Treasuries? If the focus did shift, traders would see in the US the second lowest benchmark lending rate of the G10, an oncoming recession and a severely burnt investor base. On the other hand, most major economies are suffering from similar conditions; so evaluating the dollar’s strength would not be so cut and dry. Another Fed rate cut could help create a bias. The policy board is scheduled to meet next week and Fed Fund futures show an 82 percent probability that the group will deliver a 50bps cut.

The health of lender and investor confidence is of primary concern for policy makers and investors – even after the global liquidity injections and bailout efforts.  Though the panic that was so prevalent a few weeks ago seems to have been curbed, risk appetite continues to plunge, the probability of further bank failures is rising, and – most importantly of all – the market is still vastly overleveraged. Even though the world’s largest central banks have guaranteed short-term funding, investors and businesses will still look to reduce their risk exposure – it will merely come in a more orderly fashion.  

While the markets are still on high alert, the consumer sector has yet to really feel the full weight of an economic slump and second round effects of the financial crisis. Evidence these conditions are approaching are growing however. The seizure in lending rates has already had its impact on revolving credit and longer-term loans like home mortgages. Banks are actively raising reserves, boosting their own lending conditions and passing on the additional regulations that the government has passed. As for the economy, 3Q GDP numbers are expected to confirm the first step into a recession next week.

US capital markets were consolidating for much of the past week; but the sharp declines across all asset classes today should remind market participants that conditions are far from normal. In the equities markets – the benchmark for risk appetite – volatility is still at historical highs (though it has receded from the records that were set over previous weeks). The heightened activity in the markets merely reflects the fear that is still looming over the investment community. Many have pointed out the government’s efforts to stabilize credit markets through its massive liquidity injections and ever-evolving bailout plan; but this massive endeavor is geared towards securing the normal functioning of the markets. Even if overnight lending rates have eased, there is still a lack of a market for illiquid assets. What’s more, a recession would lead to a natural bear market which will leverage investors’ desire to reduce risk.

It used to be that a few years worth of price history could reveals the overall conditions of a specific market or asset. Nowadays, all that is needed is a few months worth of data. In such a period of a time, the benchmark Dow 30 has plunged another 30 percent to test five year lows. Showing that there is no safety in physical assets, the CRB commodities index has dropped a staggering 44 percent to a new four year low of its own. Even age old axioms like a rise in general bonds leads to a fall in shares has started to breakdown with all the unwinding.

Risk aversion is the culprit to the market’s ongoing malaise. Despite governmental intervention, investors and counterparties are still fearful of rising bankruptcies. In fact, default premiums are just off record levels. Working further into sentiment, the 10-year Junk bond spread has soared beyond post-9/11 and the Dot.com failure levels to a record of its own. Even the most accessible fear gauge, the VIX, has held to highs not seen since the 1987 market crash. And, for a comparison to ’87, we now have a market crisis and economic recession to build momentum.