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Dollar Struggling as Risk Appetite Improves, Policy Outlook Dims

Dollar Struggling as Risk Appetite Improves, Policy Outlook Dims

2010-03-17 22:50:00
John Kicklighter, Chief Currency Strategist

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The Economy and the Credit Market

This past week, risk appetite found a temporary foothold and the timetable for a rate hike from the Federal Reserve was pushed back. However, despite this usually ruinous combination of events, the US dollar has not come under fervent selling pressure. Why is this? First, we look at risk appetite. While sentiment among the speculative group has indeed improved over recent weeks, the level of conviction behind this drive has been clearly lacking. For evidence, we have seen otherwise remarkable breakouts from benchmarks like the Dow Jones Industrial Average fail to rouse trading activity and momentum. This may come as a surprise given the support that would be conferred by a round of central banks taking steps to maintain a loose monetary policy stance and the support offered Greece by the EU along with its improved credit outlook. However, these are steps of improvement in name only. Financial uncertainty in the Euro Zone, China, the United States and the rest of the world is still unacceptably high. Another reason for the dollar’s relative stability is its climb on the risk spectrum. Though the FOMC decided to keep its warning that interest rates could remain at “exceptionally low” level for an “extended period” at Tuesday’s rate decision, the general hawkish bearing on the future hasn’t suffered too much. While the timing on the first rate hike has been pushed back, market rates support a consistent tightening over the future. The US three-month Libor rate has climbed consistently from its record low and has worked to shed the unwanted title of funding currency.






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A Closer Look at Financial and Consumer Conditions

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It may seem that financial uncertainty has been significantly reduced this past week with a few key events; but the world’s level of exposure is still excessively high. The most prominent development was the European Union’s vow to aid Greece should the member need it and the S&P’s removal of its credit watch on the nation. Yet, an objective review of this combination sees the EU’s vows backed by no solid plan; and their means for implementing any support effort is even weaker. As for the stability in the nation’s credit rating, the rating agency’s outlook is still negative, and the difficulty they face economically is even greater. Adding to difficulties going forward, Moody’s has warned the US has moved closer to losing its own top credit rating. The economic outlook for the United States and the world it is set within has tempered somewhat this past week. From the Federal Reserve’s assessment, business spending has improved; but most other critical factors of activity are still struggling to viably add momentum to the economy. Consumer spending is the most prominent shortfall. Moderate growth in this area was further supported by a tempered pace of February retail sales and by an unexpected pullback in the University of Michigan’s sentiment report for March. More concerns was the evaluation that housing construction had stalled at depressed levels while jobs, wages, wealth and credit access to consumers was deemed to be weak. A robust period of expansion is a considerable ways off.


The Financial and Capital Markets

New levels of speculative optimism have been reached by key markets; but it seems that conviction is still notably absent from the mix. Whereas global equities have climbed to new year-and-a-half highs and commodities are just below their own remarkable levels, the encouragement these psychological milestones seems to be far more limited than the initial build we had seen back in 2009. This is a good representation of the difference that capital inflows and actual investment interest have on the markets themselves. On the one hand, sidelined capital is finding its way back into the speculative arena as a tentative recovery in growth and the access to credit eases encourages investment. We can see this in the steady contraction of the ICI Investment Company Institute’s money market funds asset report which is now at its lowest level since November of 2007. In contrast, there is still little to entice investment based funds (as opposed to speculative capital) to adopt more risk as rates of returns are still at extraordinarily low levels. Furthermore, the outlook for returns is diminished by the steady reduction of extraordinary levels of stimulus. With the Fed and other central banks removing guarantees and bleeding liquidity from the system, the market is increasingly dependent on its own strength.





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 A Closer Look at Market Conditions

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From the capital markets, it seems that the bull trend is back on course. At the front of the rise in risk appetite, the Dow Jones Industrial Average has joined the other US benchmark equity indexes in establishing a new 17-month high. For the commodity market, crude is not far from marking its own highs. However, background readings of market activity give reason for pause. Volume behind these markets has generally declined despite the push in the underlying to new highs. This is a divergence that often spells the end of trends. Furthermore, we can see the effect of slackened confidence in price action itself. Usually a push to new highs triggers momentum. Complacency has increased alongside the capital markets’ advance to new highs. The standard measures of volatility have fallen to new lows. In fact, the CBOE’s VIX index for equities has dropped to levels not seen since May of 2008 while the DailyFX currency-based index has tumbled to its lowest reading since September of the same year. This could be interpreted as a sign that uncertainty is low; but in reality, the outlook is perhaps more tenuous now than it was a higher levels given the market’s highs. A correction from such lofty levels could be more dramatic and damaging to confidence than a mere retracement within a broader range.

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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