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Dollar Losses on Growth Concerns Restrained by Euro Uncertainty

Dollar Losses on Growth Concerns Restrained by Euro Uncertainty

2010-07-22 22:27:00
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

The fundamental outlook for the US and its currency continue to deteriorate with each passing week. This isn’t necessarily unusual in the context of a global leveling off in economic activity; but as the proxy for the rest of the world, the United States inequities are magnified by discriminating investors. This particular scenario further leverages the greenback’s dependency on its role as a safe haven currency. That may not be a good position to be in ahead of the high-level event risk of the final 24 hours of the trading week. While there are many different elements that factor into the prevailing direction and intensity of investor sentiment, it is fair to say that one threat looms larger than others: the financial stability of Europe. While this region’s troubles with fiscal responsibility, economic growth, expected return and perhaps even the Union’s sustainability will last for many months; the stress test the government is performing on the region’s largest private banks is considered a blatant milestone for those market participants with a short attention span. Considering risk appetite trends have turned positive over the past few weeks, the market could easily adopt a positive interpretation of the results and divert capital away from the safe haven dollar. However, the understanding of this news will be far from straightforward. And, ensuring that our perspective isn’t foreshortened to just the week ahead; after the EU event bolsters volatility, the market will move on to the advanced reading of 2Q GDP for the US due next Friday.

 

 

 

 

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A Closer Look at Financial and Consumer Conditions

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When capital markets rise, the perceived structural stability of the financial system is considered to be improving. This is a fair-weather fallacy that only enhances volatility in price action when market participants’ expectations have to correct to meet reality. Speculative interests often deviate from the fundamental trends that define the markets; and we are now seeing just such a case. Currently, the US and its global peers are in a transition period where austerity and stimulus rollback efforts are in a dangerous balance with shaky economic activity levels. Should a European financial crisis, Chinese asset bubble or some other unknown element spark trouble for the global system during this particularly sensitive period, officials’ ability to offer a fix will be severely diminished. From a purely economic perspective, the US economy is suffering from the effects of stimulus withdrawal. While many have praised the performance of the world’s largest economy over the past year, there is little arguing that this strength has been heavily influenced by the liquidity and cheap loans provided by the government. Now, with deficits ballooning and policy makers under pressure to ensure credit quality, the fuel for expansion and safety net for confidence is being removed. How strong is the economy without this support? Data this past week gives us a clue. The housing market has slumped following the expiration of a specific tax incentive, consumer confidence suffered its biggest monthly decline since October 2008, retail sales contracted and the Fed’s Bernanke has lowered his outlook.    


The Financial and Capital Markets

Despite the general lack of direction to come out of the capital markets over the past week, volatility is excessively high. This is a common condition of market-wide anticipation of a particularly important scheduled event. The gravity in tomorrow’s EU Stress Test results is massive. Given speculators’ preoccupation with European financial stability (or more specifically the potential of a default amongst one of the group’s member economies), it is only natural that this definable and definite event should carry with it a high level probability for redefining the markets. In just the past week, we haven’t seen a clear direction in underlying risk appetite despite the clear recovery attempt made through the first half of the month. In fact, the correlation between the different asset classes has significantly diminished – typically a sign that congestion is the natural state of things. Clearly, that is not the case this time around. The volatility developed from typically, top-tier economic event risk has encouraged significant movement; but the lack of commitment is ensuring these buying or selling trends do not match up. The probability that the markets reconnect after this week is high. What’s more, the significance of this unusual incidence is likely to supply the resultant direction with momentum. The two most important questions going forward: how will investors interpret the EU’s report and for how long will it influence the market?

 

 

 

 

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 A Closer Look at Market Conditions

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Another attempt at producing a lasting trend has been thwarted. Regardless of what asset class we are looking at (equities, commodities, currencies, etc), we are left with an impression of congestion. Forced upon price action by an unusual and systemic risk, this interruption will not simply end with a self-developed momentum from speculators themselves. Rather, direction and intensity are fully dependent on European event risk as surely as the risk appetite itself is contingent to this threat. Should we maintain a bias into the storm? Only a long-term outlook. In the shorter-term fear or greed can generate a dramatic swing in price. We are a long way away from the level of risk premium that defined price discovery 18 months ago. The difference between conditions today and the financial crisis in the final months of 2008: the system was actually breaking down back then; while currently, the possibility that history will repeat itself is merely speculation. That being said, the market-level indicators of risk seem to be falling severely short of reality. For, example, the CBOE’s VIX volatility index is just off a two-month low and the currency version of this indicator is not far from similar levels. However, when we look at the risk tolerance at the banking level; we are confronted with steadily rising Libor rates, two-year highs in junk bond spreads and growing default premiums.    

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

 

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