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Dollar Congestion Sets in as Sentiment, Policy Forecast Stabilize

Dollar Congestion Sets in as Sentiment, Policy Forecast Stabilize

2010-03-12 00:25:00
John Kicklighter, Chief Currency Strategist

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


The Economy and the Credit Market

Over the past week, the US dollar has further worked its way into a complacent zone of congestion. While this may seem a reasonable push towards stability as the world’s economy moves towards recovery and global financial markets stabilize; in reality, there is still a significant gap between growth and asset values and secure financial markets are still a distant ideal. This means the steady market conditions of the past few weeks are likely a temporary state that will be shattered when the investor sentiment shifts. Whether the resultant tilt is towards the building of risky positions or further withdrawal of capital from the speculative arena will define the pace and direction of the greenback. The more severe the market’s impression of risk appetite or aversion, the more distinct the currency’s role as a safe haven currency will show through. On the other hand, recent developments have put the dollar on a better footing when it comes to the spin-off function the unit played as a funding currency through 2009. While the forecast for growth and interest rate policy in the US is restrained, economic and financial concerns in Europe have notably hindered the strength of these regional currencies. In turn, the dollar is pushed further ahead of the curve and the unit looks more like a potential carry currency (speculation of rate hikes is often more influential over exchange rates than the actual hikes themselves). However, this is a tenuous lead. A tempered forecast for the dollar or improved outlook for Europe could encourage a changing of the guard







A Closer Look at Financial and Consumer Conditions


Financial stability seems to be solidifying; yet the threats to its steady operation seem to grow by the week. This past week, China reported a surge in inflation and loan growth that further necessitates officials’ action to prevent the bursting of a potentially crippling asset bubble. Such an event would tarnish the appeal of one of the best investments for global traders over the past year and thereby dim the general outlook for risk appetite itself. From yield potential to risk the threat of losses; the situation in Europe seems to have worsened rather than improved. The UK is facing a general election and the officials have promised a hands-off approach to the deficit. In the Euro Zone, some policy makers have shot holes in the EMF proposal. There has been relatively limited event risk to reformulate an assessment on the health of the world’s largest economy. The headline figure for the past week was the February non-farm payrolls. As has been the trend for the past year or so, the pace of the labor data is improving. While the net change figure would fail to report an increase for the month, the period-to-period losses are growing notably smaller. On the other hand, the more inclusive readings of measures like underemployment, suggest the road to recovery and robust growth is perhaps longer down the road than many expect. Stick with consumers, the Federal Reserve reported the first increase in credit in a year. They also noted the third consecutive quarterly rise in household wealth


The Financial and Capital Markets

Without a clear fundamental catalyst to set speculators in the pursuit of yield or fleeing from a potential financial crisis, the market is left to its own devices. It seems in this period of ‘down-time’ that the risk appetite has established a clear trend. However, this advance has developed within the boundaries of much more influential levels. Therefore, risk appetite is allowed to appreciate (or risk aversion allowed to deflate) market values so long as it doesn’t take the critical step to establish a new and consequential trend. As such, advances in the Dow Jones Industrial Average and crude among others have occurred without a meaningful realignment of risk tolerance. This is a discouraging theory to adapt to the rebound in 2009 as it suggests a reversal is simply a bounce. To truly reestablish a bull trend that enjoys notable progress over a number of years, a number of hurdles will have to be overcome. The very basis for a recovery in markets is first and foremost the responsibility of economic activity. Beyond expansion’s influence, the rollback of government stimulus, the burden of extreme fiscal deficits and the availability of credit (leverage) are critical obstacles to deal with. In the meantime, more immediate and global threats like China actively cooling its markets, Greece’s ailments spreading across Europe or even ill-placed regulation could impact the markets in the near-future.






 A Closer Look at Market Conditions


Capital markets are running on momentum at this point. Without the immediate headlines from troubles in Greece, speculators have regained their appetite for yield. However, that does not mean the balance of risk and reward has actually improved. Events actually leads us to believe that China is losing the fight against its asset bubble, sovereign debt ratings will deteriorate globally and the US will struggle to produce the necessary yield to encourage capital inflows. What does this mean for equities, commodities and other markets? Speculative funds will be withheld from building material trends and the swing highs put into place months ago will hold. The concept and measurement of risk are relative. Compared to conditions through the final months of 2008, the circumstances for placing money to work has improved substantially. This is a comparison to a panicked period. Yet, when we compare the environment of today to one some three years ago; it is clear that the prospect of return and profligacy of money has certainly receded. We can make these same comparisons in the quantitative measurements we refer to for risk. Volatility and risk premiums are notably lower than where they were a year ago; but they are certainly not at the levels we have seen in the acceleration period of previous bull markets.

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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