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Dollar Strength Falls to Sovereign Credit Concerns Not Yield Forecasts

Dollar Strength Falls to Sovereign Credit Concerns Not Yield Forecasts

2010-05-12 22:12:00
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

 

The Economy and the Credit Market

If the financial situation in the European Union hadn’t prompted the fear of the speculative masses, the US dollar would likely not be pressing new yearly highs on a trade-weighted basis. However, this burgeoning and constant fundamental threat has permanently disrupted the balance of risk/reward that had put investors in pursuit of higher returns since the capital markets bottomed out in the first quarter of 2009. This past weekend, officials in the EU attempted to snuff out fears Greece was heading towards a default that could inevitably lead to the collapse of the euro. The ammunition used: a 750 billion euro (approximately $946 billion) rescue program that rivaled the United States’ own bailout effort back in the height of the 2008 meltdown. Can this sizable effort avert the failure of one of the world’s largest economic experiments? As long as there is doubt, the greenback will remain buoyant. The troubles in the euro-area simply remind investors of much larger troubles that have been overlooked since the last bailout. Economic activity is still depressed and will remain that way as the government withdrawals stimulus. What’s more, the cost of global intervention to prevent a full-blown system failure in 2008 was record government deficits. Now, sovereign credit ratings are at risk and the original source of the current malaise (excessive leverage) has yet to be answered. And, as long as it seems the global economy and markets are at risk, investors will look past the United States’ own indebtedness and its deficient yield expectations to harbor funds in Treasuries and other dollar-based assets.

 

 

 

 

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A Closer Look at Financial and Consumer Conditions

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While there is now a focus on the systemic health of the financial markets and the durability of investor confidence, the future is still tethered to the health of the economy. Now more than ever, the links between the performance of the US economy and the rest of the world should be obvious. For the world’s largest economy, the recovery is still underway; but the pace is certainly lacking gusto. This past Friday, the Bureau of Labor Statistics reported another 290,000-net addition to the national payrolls through April. This is a promising direction for the economy’s most influential group (the consumer); but statistics like a 9.9 percent jobless rate and slowest pace of wage growth in years should temper optimism. Construction, trade and business investment are all similarly lax in support.  The financial system was delivered a shock this past week. Already under strain by the probability of a European-born crisis; the crowd’s true face was exposed by a short period of true panic during the afternoon of the US session. The cause of the collapse is still under debate; but the evaporation of liquidity in the equities market would translate into a perfect storm for nearly every asset class. The nearly 1000-point drop from the Dow Jones Industrial Average was the most titillating statistic from the day; but the effects would ripple out to debt, commodity, currency and derivative markets. And, though there was a quick retracement of the incredible losses; investors’ predisposition to panic was laid bare. The influx of capital into speculative assets is now permanently pinched and sovereign concerns ballooning.     


The Financial and Capital Markets

Policy makers may believe the global financial markets may be able to withstand a serious jolt.  However, the evaporation of confidence as the Greek / EU crisis deepens and the market crash last week tells us that the markets are dangerously exposed to another seizure. The grounds for such a rapid deterioration in health are ample and infectious. The most immediate threat to stable, normal functioning markets would be a deterioration of the situation in the euro-area. What impact could that region’s troubles have outside its own boarders? To answer that question we only need to look at the collapse in asset prices last week or the spread of the US subprime crisis to the rest of the industrialized world in 2007-2008. The markets are interconnected; and leverage has further increased their sensitivity to troubles. The quick recovery to last Thursday’s late-US session plunge has averted an accelerated crash; but the event has levied a permanent weight on optimism. Now, investors are more susceptible of disappointing data and skeptical of positive developments. Risk premiums have picked up from yearly lows and growth-based assets retraced from equivalent highs. Now all that is needed is conviction to define whether risk aversion or appetite is the next market leg

 

 

 

 

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 A Closer Look at Market Conditions

 

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Though they have seemed unflappable in recent months, the standard measures of fear went crazy with last week’s sudden breakdown. The equity-based VIX Volatility Index surged over 15 percentage points to more than 40 percent while the currency-based equivalent jumped nearly 30 percent to a 15 percent reading. Looking deeper into the reaction, we see that credit default premiums on corporate debt surged a 10-month high while junk bond spreads have seen their quickest rise since early February. What is truly concerning though is that the panic wasn’t isolated to the highly-speculative asset classes. Sovereign credit risks are growing; and this reality could have a permanent impact on risk going forward. Last week’s severe volatility is obvious on nearly any time frame chart. The dive from the Dow this past Thursday was the most aggressive we have seen since the height of the 2008 crash in October. The difference between now and then, the previous tumble marked an exhaustion point in a well-developed bear trend. Last week’s sharp tumble comes near the very top of one of modern history’s most substantive and consistent rallies. What does this mean? If this bearish draft were contained to one asset class and risk appetite weren’t already fading, it could be written off as abnormal event consigned to the record books. However, fuel for this pain and its prevalence suggest it may only be the beginning.    

 

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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