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Dollar Fully Dependent on Safe Haven Flows at Rate Forecasts Vanish

Dollar Fully Dependent on Safe Haven Flows at Rate Forecasts Vanish

2010-05-19 21:28:00
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

The US dollar is one of the best performing currencies amongst its liquid counterparts in recent weeks. There is certainly a fundamental motive to this performance; but its dependence on speculative rather than tangible economic factors makes it a highly unstable advance. Taking stock of the dollar’s backdrop, speculation over the United States’ growth and interest rate advantage in the coming months and quarters has diminished recently. From the docket, the first quarter GDP data reported a tempering of the nation’s aggressive recovery; and more timely indicators have confirmed measured strength in consumer spending and construction activity. Investors could overlook this long-term consolidation if yield potential sweetened the risk/reward balance. However, interest rate forecasts themselves have similarly deteriorated with time. While the outlook for Fed hikes was meager a month ago, recently the 12-outlook has dropped to a paltry 41 bps. What’s more, the probability that the FOMC would put in for its first hike before the year’s close has eased to at a mere 40 percent. In the absence of strong fundamental support the stability of the greenback’s remarkable six-month trend (and the remarkable momentum of the past month specifically) is cast in doubt. This leverages the importance and influence that underlying risk appetite has over the currency’s performance. As long as fear and uncertainty feed the flight-to-safety flows, the market can overlook the concrete fundamentals. But this ignorance won’t linger forever.







A Closer Look at Financial and Consumer Conditions

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The alarm of financial crisis has dissipated somewhat over the past week; but investors have not let up on their effort to deleverage from risky positions. Since the European Union and IMF announced a 750 billion euro emergency credit line for EU members that fell on hard times, the world’s more prominent threat is being met by a large – if not ill-defined – solution. Nonetheless, skepticism remains; and the next step in the ever-evolving storm front could undermine any early hints of optimism. What’s more, fear itself is contagious; and there are many looming threats that have not yet surfaced. The most immediate hazards to stability is China’s efforts to deflate its own asset bubble and Japan’s struggles with deflation and a swelling debt load. Eventually, sovereign debt risk will reach the dollar. Just how strong is the US economy relative to its major counterparts? This is a more nuanced argument than simply comparing GDP readings amongst different economies. Pace means little in the broader scope of recovery than does consistency. The US economy has already downshifted from the impressive growth statistics that are natural in a rebound from a deep recession; but the 3.2 percent pace of annualized growth through the first quarter is nothing to scoff at. The three-year high in personal consumption trends suggests the economy has graduated from a ‘flash’ period of expansion to a lasting phase of growth. The Federal Reserve seems to interpret the same as it has raised its growth outlook for 2010 to a range of 3.2 to 3.7 percent and lowered unemployment to a 9.1 to 9.5 percent range.    

The Financial and Capital Markets

Speculation has fallen on hard times for a couple months now; but the spread of fear has only recently spread to the corners of the financial market. Under the threat of a Greek-catalyzed financial crisis, the European Union seemed to face a crippling fallout from its own ill-fitting fiscal governance. Naturally, this fear would begin with the euro and slowly spread to the more risky European assets. When debt liquidity concerns jumped to sovereign credit issues, the chance of international contagion started to bear down on the masses. This past week, multi-product international investors recalled the fallout from the 2007-2008 subprime crisis and attempted to cash out of their high-risk positions in an orderly fashion (as opposed to the previous panic selling of May 6th). Gauging the relative level of speculative premiums holding over from the 2009 build up and the troubles that present themselves a little further down the road, there is a strong argument to be made for further deleveraging. The most immediate concern for investors is further deterioration in the EU situation. Should the region’s bailout plan fail to prevent a default, there will be an immediate rush to dump exposure. Further down the road, we start to move into debt and sovereign credit concerns. The cost of the global bailout in 2008 has to eventually be reconciled.






 A Closer Look at Market Conditions


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Any doubts that the capital markets are turning over following the impressive 2009 rally have been washed out by steep declines over the past month. The question that anxious speculators are asking now is when they can call a bottom. Putting the retracement to this point into context, the Dow Jones Industrial Average has only worked off a mere 16 percent of its peak-to-trough rally through April. Working a little more quickly (and more closely tuned to growth trends rather than pure speculation), crude oil has retraced nearly a third of its initial rally. From a purely technical standpoint, there is plenty of room to fall. A reversal in underlying price action without an equivalent rise in risk premium is typically a sign that a trend will be tame and/or short-lived. This was the general condition that accompanied the initial build up in speculative positioning over the past year. And, until recently, the reversal in the few key benchmarks was not accompanied by a sense of fear. However, as the bearish sentiment matures, the withdrawal has become less orderly. From the standard measures of fear, the CBOE’s VIX volatility index has held near its highest levels in a year while currency activity has reached similar highs. Looking beneath the surface, CDS and junk bond premiums have risen and the outflow from money markets has reversed.    


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


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