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Dollar Will Have to Look for Favorable Risk Trends without Fed Support

Dollar Will Have to Look for Favorable Risk Trends without Fed Support

2011-02-05 06:42:00
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

Credit Market

Previous

Current

Change

% Change

Outlook *

DJ Credit Default Swaps

82.714

82.763

0.050

0.06%

Deteriorating

10 Year Junk-Bond Spread

472.48

464.30

-8.18

-1.73%

Improving

Credit Card Delinquencies

4.15

3.91

-0.24

-0.24%

Improving

Mortgage Delinquencies

9.85

9.13

-0.72

-0.72%

Improving

US 3 Month Libor Rate

0.304

0.311

0.00612

2.01%

Improving

Total Money Market Funds

2787.84

2757.48

-30.36

-1.09%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

11985.44

12041.97

56.53

0.47%

Improving

Dow Jones Real Estate Index

222.7

225.96

3.26

1.46%

Improving

Dow Jones Financial Index

380.81

384.62

3.81

1.00%

Improving

Dow Jones Retail Index

91.54

92.7

1.16

1.27%

Improving

S&P Volatility

16.64

17.3

0.66

0.66%

Deteriorating

Put-Call Ratio

1.06

2.35

1.29

1.29%

Deteriorating

Market Breadth (Adv - Dec)

0.4214

0.5079

0.0865

8.65%

Improving

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

3.2

3.2

3.20%

Improving

Mortgage Applications

-12.9

11.3

11.3

11.30%

Improving

Initial Jobless Claims

420

454

34

8.10%

Deteriorating

Consumer Confidence (CB)

53.3

60.6

7.3

13.70%

Improving

ISM Manufacturing

58.5

60.8

2.3

3.93%

Deteriorating

ISM Services

56

57.1

1.1

1.96%

Deteriorating

ISM Services - Employment

53.6

52.6

-1

-1.87%

Deteriorating

An Improving outlook means the Federal Reserve coulduse thisindicator

to support a rate hike. The opposite stands for a deteriorating outlook.

The Economy and the Dollar

Dollar_Will_Have_to_Look_for_Favorable_Risk_Trends_without_Fed_Support_body_Picture_1.png, Dollar Will Have to Look for Favorable Risk Trends without Fed Support

While the dollar can find a temporary, favorable wind through many different fundamental and speculative sources; a serious and lasting advance from the greenback can only truly be generated via a few catalysts. What makes the dollar’s medium-term outlook seem particularly dubious is that those encouraging factors are either far off into the distance or contradict the current trends in the broader market. With the pressure of a 10-year, progressive decline for the benchmark currency (owing to the gradual diversification of reserve and risk-free funds); the most prolific fundamental advance the dollar could muster would be as a global leader for returns in both economic growth and asset returns. Given the healthy 3.2 percent pace of annualized growth reported for the fourth quarter and the IMF’s 2011 forecasts, it would seem the US is well positioned in this regard; but persistently high unemployment and the temporary stop-gap of stimulus funds represent a hurdle to true economic strength. What’s more, the Fed’s maintenance of QE suggests benchmark rates will be held low through much of the year, which in turn will keep foundation for rates of return depressed as well. Better potential (though less impact) for the dollar would be a meaningful drop in risk appetite that caters to the currency’s safe haven role. Investor sentiment seemed to waver a few times these past couple of weeks; but government support and market participants’ confidence in stability have held back the tide. However, with each week that passes without a cleansing correction, the greater the risk of just such an event.

A Closer Look at Financial and Consumer Conditions

Dollar_Will_Have_to_Look_for_Favorable_Risk_Trends_without_Fed_Support_body_Picture_7.png, Dollar Will Have to Look for Favorable Risk Trends without Fed Support

Looking for cracks in the global financial system; it isn’t difficult to identify those concerns that can develop into genuine crises. However, whether or not these stress points undermine the risk appetite or the stability of the financial markets depends on the collective beliefs of investors. In the US, the approach of the nation’s debt limit seems to be on a short countdown. However, despite the implications of a technical default on what is essentially the world’s benchmark risk-free asset; most believe the cap will simply be pushed higher. The fact that the deficit continues to balloon seems to be treated as a triviality. Along similar lines, the imbalances between the advanced economies and emerging markets; the pressure in China’s markets; and Europe’s financial woes have been discounted.

Dollar_Will_Have_to_Look_for_Favorable_Risk_Trends_without_Fed_Support_body_Picture_10.png, Dollar Will Have to Look for Favorable Risk Trends without Fed Support

Between this past week and the one before, we have been given a remarkably clear view of the US economy. From the fourth quarter GDP reading, we see that the world’s largest economy is once again running at an impressive clip owing to the biggest contribution from consumer spending in four years and the best showing in exports in three decades. However, we need to reconcile this remarkable performance with the concerning level of unemployment. Though the jobless rate unexpectedly fell to its lowest level in 21 months, it is still exceptionally high while those dropping out of the labor pool but still want work continue to hit new record highs. Americans cannot afford to keep spending on credit alone (if they try, it would setup another credit crisis). And, the US consumer is the largest net buyer globally.

The Financial and Capital Markets

Dollar_Will_Have_to_Look_for_Favorable_Risk_Trends_without_Fed_Support_body_Picture_4.png, Dollar Will Have to Look for Favorable Risk Trends without Fed Support

The capital markets – and the sentiment behind them – seem to have recovered quickly from last Friday’s slip. The divide between blind speculation and economic performance is not very clear at this point; and the ambiguity of the latter is propping up the health of the former. With headline readings like those seen with the fourth quarter GDP reading and January jobless rate, it is easy to overlook the financial risks of pushing assets higher. However, the outlook for revenues, dividends and yields simply does not reconcile with the expectations derived from the relentless climb in capital markets. It isn’t difficult to call up an example of what happens when prices swell beyond what natural returns can support. The most poignant example is the 2007-2009 financial crisis. It is easy to simply disregard such a comparison between now and then; but the conditions are very similar. The overabundance of debt and the inability to sustain its necessary payments simply met an overdue reality check form market participants. What has changed now? Leverage has not really been reduced, it has simply been transferred from one player to another (the investor and consumer to the government). Eventually, these liabilities will be transferred back to their owners or there will be more turmoil like what was seen in the EU or preliminarily with China. Another concerns that should not be overlooked is global inflation. While many central banks believe there isn’t enough price growth to hike rates, there is enough to cut revenue.

A Closer Look at Market Conditions

Dollar_Will_Have_to_Look_for_Favorable_Risk_Trends_without_Fed_Support_body_Picture_13.png, Dollar Will Have to Look for Favorable Risk Trends without Fed Support

There is a two speed performance between physical and financial assets. Those intangible investments that yield interest continue their slow appreciation as expected risk slips to its lowest levels since before the last financial crisis. However, for commodities, the climb has been far more rapid. Here, speculation meets a genuine concern over limited supply. The global economy may still be recovering from its first recession in decades; but its pace seems robust enough that demand for staples is surging beyond the capacity for production. Looking out over 3, 6 and 12 months, it will be important to gauge speculation’s influence here.

Dollar_Will_Have_to_Look_for_Favorable_Risk_Trends_without_Fed_Support_body_Picture_16.png, Dollar Will Have to Look for Favorable Risk Trends without Fed Support

The benchmark equity and commodity indexes are forging new multi-year highs and implied risk measures have fallen to equivalent lows. This may seem like two unique indications that confidence has returned and the markets are set within a cyclical growth phase. Yet, in reality, price and the cost of insurance are intrinsically linked – not by nature but rather through sentiment. Speculative interests can easily feed assets higher as the desire for return outpaces the risk of loss. That said, risk can – and should – rise alongside the appreciation of expected returns. It is one of the innate laws of investment that higher returns are born out of greater risk. The fact that risk measures are not rising speaks to willful ignorance.

Written by: John Kicklighter, Currency Strategist for DailyFX.com

To receive John’s reports via email or to submit Questions or Comments about an article; email jkicklighter@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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