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Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

2011-02-11 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

82.043

81.985

-0.058

-0.07%

Improving

10 Year Junk-Bond Spread

464.3

436.66

-27.64

-5.95%

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

0.311

0.312

0.0015

0.48%

Improving

Total Money Market Funds

2798.65

2746.94

-51.71

-1.85%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

12062.26

12229.29

167.03

1.38%

Improving

Dow Jones Real Estate Index

226.56

228.29

1.73

0.76%

Improving

Dow Jones Financial Index

382.02

393.66

11.64

3.05%

Improving

Dow Jones Retail Index

92.99

93.73

0.74

0.80%

Improving

S&P Volatility

16.69

16.09

-0.6

-0.60%

Improving

Put-Call Ratio

1.67

1.66

-0.01

-0.01%

Improving

Market Breadth (Adv - Dec)

0.5049

0.5701

0.0651

6.51%

Improving

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

3.2

3.2

3.20%

Improving

Mortgage Applications

11.3

-5.5

-5.5

-5.50%

Deteriorating

Initial Jobless Claims

411

383

-28

-6.81%

Improving

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

57.1

59.4

2.3

4.03%

Deteriorating

ISM Services - Employment

52.6

54.5

1.9

3.61%

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_Eyes_Rebound_as_Event_Risk_Fills_Out_Stimulus_Under_Review_body_Picture_1.png, Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

The US dollar hasn’t taken that critical step to secure a true reversal; but the fundamental drivers that would achieve the necessary shift are starting to line up. From price action alone, this past week has proven to be relatively quiet given the lack of scheduled event risk and off-the-docket developments. However, the benchmark currency finds itself loaded with potential energy that can quickly turn kinetic given the right catalyst. Taking stock of the strained position the dollar finds itself, EURUSD is eyeing the 1.3550 level that has held the pair back from retracing its January rally for three weeks, GBPUSD has settled on the floor of a 1,000-point rising trend channel and AUDUSD has once again dropped back to parity. What can lead the dollar to that next step in a reversal? As it happens, two of the three most critical fundamental drivers behind the currency have already started to line up. Relative growth (and the forecast for that lead to hold up) has already been accounted for. New to the mix but still hesitant in its support of the greenback is early speculation that the second stimulus program could come under review. Early commentary doesn’t necessarily mean the Federal Reserve will immediately abandon the loose policy stance; but the speculative crowd priced in the adoption of QE2 well before the actual November announcement. So, it stands to reason that the forecast for its withdrawal will pique curiosity. And, finally, there is risk appetite. Holes have been punched in sentiment; but the benchmarks for speculative positioning have yet to give up a reasonable portion of their gains.

A Closer Look at Financial and Consumer Conditions

Dollar_Eyes_Rebound_as_Event_Risk_Fills_Out_Stimulus_Under_Review_body_Picture_7.png, Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

It is easy to see stability in the financial markets when the assets that comprise them are stable and values are high. However there is certainly reason to be concerned about US and global market conditions. Domestically, the Fed has to keep an eye on the distorting effects of stimulus; but a tightening of the monetary reins is inevitable. When that happens, the mortgages that have held out due simply to the record low benchmark lending rate will start falling into default. Expanding our view globally, we noted that Portuguese 10-year government bond yields rose to a record high despite the open-ended promises EU officials made for March. And, in Asia, China clearly is concerned about instability as it hiked the benchmark lending rate for a third time since October.

Dollar_Eyes_Rebound_as_Event_Risk_Fills_Out_Stimulus_Under_Review_body_Picture_10.png, Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

There were relatively few updates on the health of the US economy over the past week through traditional means; but those developments that did transpire added to the picture of a robust (though perhaps not exactly consistent) recovery ahead. Off the docket, various Fed policy officials voiced confidence in the economic recovery – and a few were optimistic enough to warn that the stimulus may need to be removed before its natural expiration if trends hold. For data, the January NFPs showed a weaker-than-expected addition while the jobless rate dropped primarily because of a record exit of despondent American’s from the labor market. That said, labor conditions are slowly improving. Looking ahead, we have consumer confidence, retail sales, CPI and a range of other important indicators.

The Financial and Capital Markets

Dollar_Eyes_Rebound_as_Event_Risk_Fills_Out_Stimulus_Under_Review_body_Picture_4.png, Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

There is a notable deviation between the various benchmark asset classes. Where currencies have oscillated in their performance along the lines of carry interest and economic performance; the US benchmark equity indexes have charged forward to fresh two-and-a-half year highs. How are these differences in performance and implicit projections reconciled? Through stimulus and other transient factors. The moral hazard that governments were so fearful to encourage back during the worst of the housing crisis has shown itself to be a critical factor in the capital market’s climb since the market bottomed out. As a natural sequence, the injection of funds directly into the financial system (meant to keep interest rates low) translates into banks holding a greater level of capital. Policy officials would prefer this capital be redirected to lending to jump support the economy; but there is still considerable risk in that venture. Instead, industrious banks put the money to work in investments that have proven to be unnaturally consistent in their returns (and perhaps even flooding emerging markets and inflating commodity prices at the same time). And, to ensure there isn’t a pang of conscience to this, the fact that the original stimulus program was in response to instability amongst financial players; the market inherently expects protection from adverse market conditions going forward.

A Closer Look at Market Conditions

Dollar_Eyes_Rebound_as_Event_Risk_Fills_Out_Stimulus_Under_Review_body_Picture_16.png, Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

The performance of equities and commodities is remarkable. Looking at the Dow Jones Industrial Average and the CRB Commodities Index (the benchmark for the two asset classes), fresh highs after an unprecedented and steady climb suggests either a global economy that is the prime of its growth phase or a market without significant risk. We know that neither of these is the case; but when the market becomes acclimated to such consistent trends; it can be difficult to break them of the cycle. Yet, when we see unusual developments like these, they almost always end with dramatic revisions to realistic and fundamental means.

Dollar_Eyes_Rebound_as_Event_Risk_Fills_Out_Stimulus_Under_Review_body_Picture_13.png, Dollar Eyes Rebound as Event Risk Fills Out, Stimulus Under Review

The traditional measures of risk are more than disconnected from the reality of the situation; their standings inadvertently pose the perfect contrarian reading. What are we to gather from currency market volatility readings at multi-month lows and the VIX diving plunging levels not seen since well before the financial crisis took off? What about yield differentials between so called junk debt and safe haven Treasuries narrowing to levels consistent with a steady economy? An improvement in these various measures is reasonable as the specter of a crippling global crisis eases. That said, the absence of a crisis state and the onset of a robust period of expansion are two different things. Something will give; and it will likely be traders’ confidence.

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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