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Dollar Forces an Essential Breakout but Where is the Drive?

Dollar Forces an Essential Breakout but Where is the Drive?

2010-03-25 02:37:00
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

After a month and a half of drifting, the US dollar has finally made a defining bullish break. However, whereas the long period of congestion would develop against notable fundamental winds (steps from China to cool its markets, a deterioration of EU stability and the first tangible traces of dollar-based interest speculation), the return to 2010’s dominant trend seemed to lack drive. Certainly, conditions have improved for the greenback over time. The relative growth and yield forecasts for the United States and its benchmark currency have developed a notable investment appeal to compliment the unit’s safe haven status. However, why would the market make its move now without a tangible catalyst to set things in motion? Looking at the headline event risk for the day, the dollar’s push can be attributed to ongoing troubles in the debate on how best to prevent a Greek default along with Portugal’s downgrade (EURUSD is the most liquid pair in the world and therefore sets the dollar as the most readily available alternative); but a true flight-to-safety would likely have led to a meaningful unwinding of risky positioning. Yet, equities were relatively stable and other growth-sensitive assets would avoid the telltale shifting of capital. The dollar can theoretically carry itself should buying pressure build momentum; but a genuine trend would eventually require a critical support in the form of one of the major fundamental themes: risk trends or interest rate potential.







A Closer Look at Financial and Consumer Conditions

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Financial stability is a mixture of opposing developments. On the one hand, the traditional capital markets maintain their bullish trajectory though there is little momentum or fundamental backing to support it. On the other, the cracks in the systems unquestionably shaky recovery are spreading every day. The most immediate concern is the stability of the European Union with Greece threatening to seek IMF financing should the group fall through on support and Portugal receiving a credit downgrade from Fitch. Closer to home, after Moody’s warned that US (among other industrialized nations) moved closer to losing its top credit rating, a near-record $42 billion, five-year Treasury note auction would meet the weakest demand since September. Following the Federal Open Market Committee’s assessment of a gradual recovery with mixed sector health, the market’s assessment of the world’s largest economy hasn’t changed dramatically. However, in a world where returns are relative, the US has actually seen its clout grow as the Euro Zone bickers over its rescue approach to struggling members and the UK approaches a general election that leaves its outlook highly uncertain. For the market’s point of view on the economy’s health, we can refer to US Libor rates. While also a reflection of interest rate expectations and fiscal stability, these factors have changed little over the past couple weeks while his benchmark market rate has set off on its most convincing rise since the beginning of 2009.


The Financial and Capital Markets

Each day that passes, the Dow Jones Industrial Average leads the assessment of market optimism higher. Despite a distinct lack of support for a ‘V’-shaped economic recovery and/or a dramatic recovery in revenues, this benchmark equities index reflects a steady building of risky positions. Without a notable improvement in the background economics of this capital market advance, this move is fully set open the shoulders of a speculative crowd that is looking to buy low and sell high. Longer-term investors, who lend stability to the market by holding through short-term swings, are still off on the sidelines given a clear lack of interest income to be made. This is an especially dangerous situation for the market to be in considering the US and world governments are making a concerted effort to withdrawal stimulus from the system. It is under these conditions that a simple move among a considerable segment of the market to book profit can turn into a full blown wave of selling pressure. What would be the catalyst for such a move? It is difficult to say because greed can overpower rational thinking for a long time. However, if the currency, commodity and debt markets start to give, the more popular equity world could be soon to follow.   






 A Closer Look at Market Conditions

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Looking at the various capital markets, we can point to interesting disparities in pace and direction. The stock market is the stand out with a steady climb to 18 month highs that seems to defy gravity and fundamental strength. This is also the area in which speculative interest is most active. Highly liquid and with easy access to the retail sector, this advance could be running through sheer capital inflows into the market. In contrast, the CRB commodities index shows an asset class that has met and retraced from its high. Even the government debt market is starting to show the stress of uncertainty that is inherent with questions over sovereign health. If there were ever unsubstantiated indications of stability and risk appetite set against an otherwise dangerous backdrop, this would be the time for it. Looking at the equities-based VIX Volatility Index from the CBOE, the potential for a sharp correction for the S&P 500 is still at its lowest level in nearly two years. And, while the currency-based volatility reading has bounced recently, the general level is still significantly depressed. Taking other indicators to task, we see a steady inflow of capital from money market funds and depressed levels of risk premium within credit default swaps and junk bond spreads. Clearly, this is a complacency that should raise concern.


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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