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Dollar Maintains Safety Appeal, Finds OECD Support for Fed Hikes

Dollar Maintains Safety Appeal, Finds OECD Support for Fed Hikes

2010-05-26 22:03:00
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

Though the past week was characterized by a few volatile swings in risk appetite, the capital markets nonetheless find themselves pushing towards new bearish extremes. For the US dollar, this uncertainty and pessimism bodes well for two reasons. The first benefit that this cautious state bestows upon the greenback is the consistent demand for a safe haven. With time, the trend of deleveraging away from risky positions has grown to be less panicky and more resolute. This furthers the benchmark currency’s status amongst its peers as appreciation from alternatives like the Japanese yen are more appropriately an effort to unwind carry exposure to raise capital. The other advantage from a market-wide decline in risk appetite is that growth and interest rate forecasts deteriorate across the board. So, while the outlook for expansion and the timing for a return to a hawkish policy regime for the US has slackened; the dollar nonetheless maintains the advantage over the euro, pound and yen. Furthermore, it is likely the case that fear has been applied too broadly, which has in turn minimized growth and yield premiums. However, as data and officials forecasts continue to cross the wires and the capital markets’ decline finds stability, the market will make more sensible assessments of relative strength. That being the case, the OECD’s forecast for 3.2 percent growth this year and a recommendation for Fed hikes before year’s end, adds fundamental weight to a speculative advance.







A Closer Look at Financial and Consumer Conditions

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Panic is giving way to rational pessimism. Considering the unstable source of the global recovery was bound to moderate and the stimulus-funded advance in capital markets was living on borrowed time, it was a foregone conclusion that 2009’s stunning reversal in economic and financial activity would level off. However, during the initial recovery and recapitalization period, a necessary rebound would ultimately revive dormant speculative interests. With many investors using the opportunity to recoup losses suffered during the 2007-2008 market collapse, sentiment would well over-step fundamental reality. And, since the threat of another financial crisis has snapped the markets from its one-track mind for capital gains, there is now excess premium to work off. When the mood across the speculative markets is positive, promising signs of activity are leveraged and discouraging reports are discounted. The opposite scenario is just as influential; and such a state just so happens to be befalling us now. A series of positive economic indicators has crossed the wires over the past few weeks; but the discouraging details are gathering more interest this time around. For example, a rise in existing home sales has been offset by the biggest increase in inventories in over 10 years. Similarly, Tuesday’s rise in consumer confidence is eclipsed by the fact that current conditions have stalled near recent historical lows. Where does this leave the OECD’s upgrade to growth and interest rate active for the US? Until the focus shifts from risk aversion back to relative strength, this booster may be discounted until later.    

The Financial and Capital Markets

After a notable correction took some of the pressure off a month-long effort to sell off risky assets and diversify into relatively safe assets, the capital markets are once again pressing forward with the larger bearish bearing. In the past few weeks, the benchmarks for the major asset classes have not forged ahead with follow through on probes to new lows. This essentially leaves the capital markets with the air of congestion even though positioning has deteriorated more recently. Yet, this is a standoff that will not likely last for long. The speculative crowd is already stained with a pessimistic bias; so that all that is needed to revive the selling effort is a meaningful disappointment from the fundamental docket or even a wave of speculative unwinding itself. Looking for specific and predictable catalysts, next week’s nonfarm payrolls, a few interest rate decisions or commodity group GDP numbers could start the ball rolling. However, as has been the case since the sentiment turned back in December, the catalyst and fuel behind another phase of the bear trend will likely originate from the market itself. Something to further the development of the EU financial crisis, inflame fear over sovereign debt risk or something as yet unforeseen would find an already fearful crowd to manipulate.






 A Closer Look at Market Conditions


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Though the general sentiment behind the financial markets has been one of congestion over the past week, the capital markets have made significant progress towards a further depreciation of asset value. The most prominent performance comes from the benchmark Dow Jones Industrial Average which has both tested new six month lows and put in for its worst close since February. The most recent decline though has yet to fully clear the May 6th “flash crash,” and until this psychological barrier is cleared, the next bearish phase may hold off. In contrast, the commodities (which didn’t rebound like equities) have begun to edge higher after congestion. The standard measures of volatility may not offer the best assessment of potential market risk. Over the past week, the equities-based VIX has eased from a 48 percent reading to 35 percent while the currency equivalent has eased off a 13-month high. This relief is partly a reflection of the fact that benchmarks have only recently begun to retest recent historical lows and indentifies more with complacency rather than a true reduction in risk. For contrast, the measures of uncertainty at the banking level and institutional levels (which are less volatile) have maintained their elevated status. Junk bond spreads, credit default swap premiums, Libor rates, the TED spread and other standards all continue to inflate.    


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


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