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Dollar Suffers from a Dim Fundamental Outlook, Rising Risk Trends

Dollar Suffers from a Dim Fundamental Outlook, Rising Risk Trends

2010-07-07 22:50:00
John Kicklighter, Chief Currency Strategist
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WFW-10-07-07-01

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

Was the fundamental outlook for the dollar ever that strong? Up until a few months ago, the benchmark currency was considered to be one of the best positioned currencies for economic performance and interest rate potential amongst the majors. However, on review of this appraisal, the outlook for interest rates has always been extraordinarily anemic; and though the forecast for growth has maintained its edge over many of its counterparts, the outlook is still weak on a historical basis. Nonetheless, currency traders were willing to overlook this paltry advantage as the greenback would offer greater value in the form of safety. That was the case until the past few weeks. Though risk appetite had declined severely over the past two weeks, we have seen a more extraordinary correction just this week. What’s more, the dollar itself has deviated from the path that equities and other risk-based assets have carved. A consistent selling pressure has taken over for the greenback regardless of the bearings that underlying sentiment would suggest. A surface review of developments over the past week may lead the novice trader to assign the currency’s weakness to the poor performance of the US nonfarm payrolls report – yet that was merely a coincidence of timing. The true source of this divergence is more likely the revived confidence in the Euro and the financial system that it represents. Positive developments may not ensure a dramatic recovery for the region; but it does cast doubt over the consistent and aggressive plunge in EURUSD.

 

 

 

 

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A Closer Look at Financial and Consumer Conditions

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The perception of financial stability in the US has diminished slightly while that of the entire globe has improved markedly over the past week. In the US, concern over the ballooning fiscal deficit the country is running is growing at an exponential rate. The funding gap is expected to break their self-imposed cap before the end of the year; and officials voiced no interest in abandoning loose monetary policy in favor of fiscal restraint at the G20 meeting. On the other hand, the European leaders have taken significant strides towards frugality. And, rewarding this effort, we have seen better results at EU member bond auctions and a drop in liquidity demand through the ECB’s facility programs. This reduced concern in the euro and general boost in sentiment in turn weighs the dollar. Despite the changes in monthly economic data these past few weeks, the general outlook for growth in the US this year has changed little. There has always been a sense that the world’s largest economy would see a moderation in activity levels as the recovery phase rolls over to a meaningful growth period. However, this is the same general assessment that can be assigned to the entire globe; and the moderation scenario is perhaps more severe for emerging market economies (fronted by China). Nonetheless, speculative interests leverage the currency’s response to small fluctuations in performance indicators. For that reason, the 125,000 person net drop in June payrolls acts as a clear break on confidence. This was more or less in line with expectations; but the reality of the situation is still disconcerting.    


The Financial and Capital Markets

Risk appetite in the speculative markets has been extraordinarily volatile over the past week. The unusual developments in price action can be partly attributed to the extended holiday weekend for the US. With banks offline this past Monday in one of the largest financial markets in the world, there was a marked drop in trend development through the prior Friday and continued moderation on the following Monday. However, this lull aside; we have seen a dramatic pace and remarkable reversal in risk-based assets between this week and the one prior. Assessing the situation through the final two weeks of June, there was a marked drop in equities and commodities that seemed to confirm the extension of the bear trend that has started to develop through the third quarter. That being said, the return of market liquidity this week has brought with the sharpest appreciation in risk-based markets that we have seen in months. Few would use the week-to-week shifts in price action to decisively label a new trend. In fact, the strong performance of the past few days conflicts with the bearing of the past few months – a move that has extended bearish progress with new multi-month lows established just this past week. Caution and flexibility are crucial at such moments.

 

 

 

 

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 A Closer Look at Market Conditions

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For the investor wishing to get a timely sense of risk appetite, the only analysis that needs to be done is a quick review of the more speculatively-minded capital markets. Both equities and commodities soared Wednesday. What is interesting about this move is that it does not have connections to a specific piece of event risk. Rather, this is a response of speculative interest as it pertains to the general health of the fundamental forecast. As a strong assessment of the situation, we merely need to point to the one-day 3.1 and 2.9 percent rallies from the S&P 500 and crude respectively this week. Yet both moves come amid a larger bear trend. There is little doubt that the short-term balance of risk and reward has tilted over the past few days. Confidence has swelled remarkably in a very short time; and those simple indicators that follow price as a gauge for sentiment would obviously take heed. Yet, that does not mean risk appetite has reversed for good. Credit default premiums are still extraordinarily high and yields on those assets that are considered high risk (some European government debt could fit into that category) have not enjoyed the same performance as speculative assets like stocks. A more stable assessment can be found in euro-based 3 month Libor rates (for a view of the region’s crisis) which have just recently grown to 10-month highs.    

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

 

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