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Dollar Revival Depends on its Link to Risk Appetite, Market Rates

By , Chief Currency Strategist
01 October 2009 00:33 GMT

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The Economy and the Credit Market

 

Does the US dollar make the best funding currency for a market that is recovering its sense of volatility and risk appetite? Perhaps in the short-term; but looking months ahead, the world’s most liquid currency will eventually climb up the yield scale and in turn diminish its usefulness as a source of investor lending. And, while there are many fundamental considerations and concerns driving the fate of the greenback; this particular interest seems to be holding market participants’ immediate attention. With the benchmark, three-month Libor rate consistently pushing record lows (lows that are at a discount to even Japan’s benchmark) and the demand for competitive returns on the rise; the negative correlation that the dollar has maintained to risk appetite has kept it under pressure. Recently however, we have seen some signs of life from these key yields. Complimenting the certain turn in risk appetite, we have seen policy makers indicate their intentions to roll back stimulus while data confirms a steady recovery from recession. Yet, how much of its reputation and lost ground can the currency recovery with deficits ballooning and reserves slowly but surely being diversified away from dollars?

 

 

 

 

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A Closer Look at Financial and Consumer Conditions

 

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Over the past week, policy officials from the US and other major industrialized economies have offered remarks to the effect that financial conditions continue to improve. However, these optimistic assessments are constantly counterbalanced by warnings of downside risks. The IMF has taken it a step further and given a sense to how desperate the situation may become. In its Global Financial Stability report, the group estimated that the global markets have only accumulated half of the losses that the financial and economic crisis will eventually tabulate. On a more positive note through, the outlook for total losses between 2007 and 2010 was lowered to $3.4 trillion from the $4.0 trillion estimated in April. Clearly, we are not ‘in the clear.’

 

 

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The pace of US economy continues to improve; but it is still a long way from the level of growth that was prevalent only a few years ago. Data released over the past week helps to bolster confidence while simultaneously keeping appraisals grounded. The final reading of 2Q GDP performed this function nicely when it unexpectedly reported a positive reversion. However, despite the uptick, the world’s largest economy would still contract 0.7 percent in the year through June. Component indicators reveal that the vital elements of growth (like personal consumption, capital expenditures and residential investment) are still struggling; and the temporary support of government spending is still shouldering a significant share of the nation’s recovery.

 

 

The Financial and Capital Markets

 

There has been an interesting contrast developing in financial markets that have grown very comfortable with coordinated moves. In the past weeks and months, the step-for-step moves between equities, commodities, and the dollar have started to produce gaps and lags. Though still a tentative development, it is nonetheless indicative of risk appetite losing its all-consuming influence over most major asset classes. Aside from the direction and pace of risk appetite, this link between the various asset classes is a key barometer to the health of the markets. Currently, the appreciation in yield-laden securities across the board is a sign that capital is flowing in from risk-free assets and being redistributed into any viable, liquid market. In and of itself, this is a promising development when coming out of a financial crisis; but a true bull market would experience more competitiveness in seeking out return. Another drawdown of a market that is dependent on a steady rise in risk appetite is that the subsequent skittishness can produce a market-wide correction should an event or mere shift in sentiment spark fear. Just as certainly as confidence turned the spigot for capital on, it can turn it off and even induce profit taking.

 

 

 

 

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A Closer Look at Market Conditions

 

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The capital markets continue their climb; but progress is growing more and more measured. Both equities and commodities have been supported by the positive data that has crossed the wires in recent weeks (like the encouraging revision in growth and steady improvement in employment trends – which economists expect will be extended with this Friday’s NFP release). However, the fundamental outlook for the different assets is starting to diverge. Equity investors are growing more and more concerned with the sizable US deficit and the slow exit from stimulus. However commodities can still find demand from the emerging markets.

 

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In the steady recovery of the markets over the past six months, we can see what kind of impact monetary policy officials and their efforts can have on the balance between fear and greed. While returns are still anemic by historical standards, investors are still desperate enough for return that they can overlook lingering problems in the financial system. Though, when the government begins to roll back the safety net, we will likely see a sure correction in sentiment. Aside from a dour outlook for growth, we have seen reports reveal a record low in US credit quality and an assessment that US banks have only reported 60% of their losses. Despite this, risk measures are still at pre-Lehman lows.

 

Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at jkicklighter@dailyfx.com.

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01 October 2009 00:33 GMT