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Dollar Retraces Gains as Sentiment Improves, Policy Speculation Eases

Dollar Retraces Gains as Sentiment Improves, Policy Speculation Eases

2010-03-04 01:26:00
John Kicklighter, Chief Currency Strategist
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Be sure to join DailyFX Analysts in discussing their outlook for the Fed and its impact on the dollar in the DailyFX Forex Forum

WatchFedWatches 1

The Economy and the Credit Market

Risk appetite has slowly recovered and the initial shock of the Federal Reserve’s surprise discount rate hike has diminished this past week. Naturally, the combined influence these two developments would have on the US dollar would further weaken the benchmark currency. However, there is a difference between establishing a new trend and moderation of an existing one. So far, this evolution falls into the latter category. In the end, the greenback has seen its value as a safe haven and an investment currency generally appreciate this year. From a yield standpoint, the increase in the rate that the central bank charges to depository institutions for loans doesn’t have the same effect as a hike to the Fed Funds rate. Nonetheless, it is a definable step in the policy authorities’ gradual shift towards tightening its belt on still-extraordinary levels of stimulus. Furthermore central bank commentary has suggested the usual target rate would not likely be as effective at normalizing policy. Given the dramatic increase in bank reserves held at the Fed (funds that were doled out in an effort to increase loans to consumers and small businesses but where effectively used as a backstop), adjusting rates on this front could represent a better move to control monetary policy. Ultimately, this is a concern for the dollar that will develop over time. The more pressing concern for the concern is its status as a safe haven. On this front, Greece has made further concessions to work down its deficit with a 4.8 billion euro cut. Yet, this only quenches short-term concerns. There is still crisis potential from the different corners of the market.

 

 

 

 

 

WatchFedWatches 2

A Closer Look at Financial and Consumer Conditions

WatchFedWatches 9

Financial conditions seem to be improving. Over the past week, economic data has reaffirmed the belief that the global economy is on pace for a slow but steady recovery. More importantly, the most imminent threats to stability have eased. The most prominent improvement would come through the perception that Greece was on a more secure after the government announced additional austerity cuts to banish any doubts that the economy would be unable to cover its debts and work down its existing deficit. This step certainly furthers the fight to bring its budget back under control; but it certainly does not answer the countries bigger troubles nor does it make its economic situation any easier. Expect Greece to be a sentiment concern for some time. The world’s largest economy is moving towards a “modest” recovery according to the Fed’s Beige Book. This business activity assessment released by the central bank two weeks before the group’s next policy meeting reported improvements in 9 of the 12 districts despite activity in the east having been hampered by snowstorms in January and February. Other notable data this past week has seen manufacturing activity growth for a seventh consecutive month while the service sector (which accounts for approximately four-fifths of economic activity) expanded at its fastest pace since October 2007. Each positive indicator offers a small but meaningful boost to forecast of recovery. This Friday’s NFPs could be a bigger step.

 

The Financial and Capital Markets

This past week, investor sentiment has once again taken up the cause to reverse the speculative slump that weighed the markets through January and through the first half of February. The impetus for this climb is ill-defined. There have been no clear and definable incidents that have dramatically altered the outlook for speculation; rather this development has come through many small steps. The most meaningful improvement in risk appetite was the moderating fear surrounding the threat of a global crisis developing from a Greek default. Like the Dubai World threat this past November, the initial danger of a sovereign failure exploits the highly speculative and reactionary nature of the capital markets. Naturally, as the initial threat passes without producing meaningful damage to the system, investors slowly find their way back into the market. This speaks to the slow improvement we have seen in the Dow, commodities, and all other assets with a definable attachment to risks. Yet, this climb is clearly defined by caution. Progress is difficult to make as bigger problems developing out of the Euro Zone is still a high probability. What’s more, the burden of a potential Chinese asset bubble, government deficits and the influence they have on sovereign debt risk, and the likelihood of significant carry-over losses from the worst of the 2007-2009 financial crisis mean the road ahead is far from clear.

 

 

 

 

WatchFedWatches 5
 

 A Closer Look at Market Conditions

WatchFedWatches 10

Was the bear trend that descended on the capital markets at the beginning of the year a correction or genuine reversal? This is the question investors – rather than traders – are asking themselves now. Taking stock of the troubles the global financial system still has to iron out and the slow economic recovery that lies ahead; it is difficult to judge whether the incredible revival in speculative interests through 2009 was justified. The massive influx of sidelined capital (without the curbs that were put in during the initial plunge) was no doubt responsible for the momentous run; but further investment at such high levels requires a far greater degree of confidence. Currently, standard measures of fear reflect remarkable stability behind the capital market’s recovery. Volatility indicators for equities, currencies and commodities are all near lows for the past month, indicating tempered concern that a sudden burst of activity could erupt and spark a painful drop in asset values. On the other hand, other indicators for risk premium reveal confidence in a stable recovery is still flimsy. Junk bond spreads and credit default premiums are still elevated from November/ December’s lows. Furthermore, the 2/10 Treasury spread (an indication of confidence) is just below a record, suggesting investors are looking for liquidity and concerned about government deficit.

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

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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