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Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

2011-02-25 05:20:00
John Kicklighter, Chief Currency Strategist
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Credit Market

Previous

Current

Change

% Change

Outlook *

DJ Credit Default Swaps

80.500

83.750

3.250

4.04%

Deteriorating

10 Year Junk-Bond Spread

451.02

445.71

-5.31

-1.18%

Improving

Credit Card Delinquencies

3.91

3.84

-0.07

-0.07%

Improving

Mortgage Delinquencies

9.13

8.22

-0.91

-0.91%

Improving

US 3 Month Libor Rate

0.314

0.312

-0.002

-0.64%

Deteriorating

Total Money Market Funds

2796.36

2756.14

-40.22

-1.44%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

12226.64

12130.18

-96.46

-0.79%

Deteriorating

Dow Jones Real Estate Index

228.79

227.19

-1.6

-0.70%

Deteriorating

Dow Jones Financial Index

396.28

384.85

-11.43

-2.88%

Deteriorating

Dow Jones Retail Index

93.81

93.23

-0.58

-0.62%

Deteriorating

S&P Volatility

16.37

22.01

5.64

5.64%

Deteriorating

Put-Call Ratio

2.09

2.51

0.42

0.42%

Deteriorating

Market Breadth (Adv - Dec)

0.6050

0.5562

-0.0488

-4.88%

Deteriorating

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

3.2

3.2

3.20%

Improving

Mortgage Applications

-9.5

13.2

13.2

13.20%

Improving

Initial Jobless Claims

447

410

-37

-8.28%

Improving

Consumer Confidence

64.8

70.4

5.6

8.64%

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_Requires_a_More_Aggressive_SP_500_Drop_to_Jump_Start_its_Rally_body_Picture_1.png, Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

When we boil down the dollar’s fundamental concerns, there are really only three major drivers that can materially alter the currency’s bearings. Relative growth expectations, yield forecasts and the balance between fear and greed have all proven meaningful contributors to price action over the past months; but at the moment, greenback traders have a more specific concern. This week, we have seen global investor sentiment suffer its most substantial shock since November as tension in the Middle East threatens a significant portion of the world’s energy supply. The implications for derailing the world-wide economic recovery and exacerbating still-troublesome liquidity problems have had a clear impact on the S&P 500 and other straightforward capital market barometers. That said, the currency market has not yet succumbed to the overriding influence of a wholesale unwinding of risky positions. Though there is plenty of fuel to see sentiment go up in flames (discussion of US stimulus withdrawal, revived fears of a European financial crisis and a forced collapse of the Chinese asset bubble among other things); the markets have yet to hit that critical stage of sentiment where all potential fundamental problems are used as justification to sell. In the meantime, the obstinate speculators will keep their eyes on interest rate expectations as a measure of potential returns. In recent weeks, talk of an early winding down of the QE 2 program has been furthered by Fed members like Hoenig and Bullard. However, that is far from the pressurized forecasts for near-term rate hikes behind the euro and pound. In essence this will stand as an indirect weight on the US dollar.

A Closer Look at Financial and Consumer Conditions

Dollar_Requires_a_More_Aggressive_SP_500_Drop_to_Jump_Start_its_Rally_body_Picture_22.png, Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

Financial market conditions have deteriorated significantly in just the past week due largely to the violent turn with protests in Libya. Tensions in the world’s largest energy producing region present a problem for a global economy that is suffering from an unbalanced and investment-dependent recovery. And yet, to this point, fear of capital losses has been the extent of the problem. To truly unsettle the markets and boost the liquidity-based safe haven characteristics of the US dollar, capital flow has to be threatened. Extreme volatility has certainly led to problems in the already inflated commodities market (margin requirements have been lifted on a number of instruments). Yet, equities, currencies, bonds and interest rate markets have seen little to truly undermine stability.

Dollar_Requires_a_More_Aggressive_SP_500_Drop_to_Jump_Start_its_Rally_body_Picture_25.png, Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

In the minutes to the Fed’s monetary policy meeting and its deliberation on the level of the discount rate; the policy authority has projected an optimistic but reserved outlook for the economy. A steady recovery is more often a sustainable one; but when investors are vying for higher-level returns when global alternatives are available, it isn’t enough for drawing in capital. Since the central bank assessment, we have seen a number of significant indicators color the outlook for us. A three-year high in consumer confidence is perhaps the most encouraging sign given the preoccupation with employment and the fact their spending accounts for approximately three-quarters of GDP. On the other hand, the housing sector is showing a worrisome effort at recovery with existing home prices dropping to a 9 year low.

The Financial and Capital Markets

Dollar_Requires_a_More_Aggressive_SP_500_Drop_to_Jump_Start_its_Rally_body_Picture_4.png, Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

Though direction and conviction may not be consistent across the different capital markets; one thing is true: volatility has seen an exaggerated surge in the past week. There is little doubt as to the catalyst of this recent turmoil. An attempt to catalyze regime change in Libya has prompted violence and has noticeably impacted energy output from one of the most petroleum rich regions in the world. Naturally the supply-demand implications this has on the price of crude is straightforward; but it may not be so clear as to how this development jumps to equities and other asset classes. With the global economy trying to nourish its less-than-robust economic recovery; rising costs for production while consumption is still weak curbs revenue potential from both sides of the equation. That means the exceptional earnings readings of the past few years will be substantially reduced. And, if they are not; skepticism will breakout and undermine the delicate balance of investor confidence. Yet, that is a longer-term development. Through the immediate future (the next few weeks), pure investor sentiment is in command. Should distant concerns of growth shake confidence, the masses will easily stumble upon further reason to fear assets have out-priced reasonable returns.

A Closer Look at Market Conditions

Dollar_Requires_a_More_Aggressive_SP_500_Drop_to_Jump_Start_its_Rally_body_Picture_40.png, Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

Taking a look at the benchmark capital market readings, we can put performance into context by looking at six months of price action. In just the past week, we have seen the most considerable correction from the benchmark S&P 500 and Dow Jones Industrial Average since November. And yet, these barometers are far from reversing their remarkably consistent bull trends. What’s more, commodities are a notable contrast to the financial assets. Prices on these necessary goods have surged in the past months as supply and demand concerns have shaken confidence. In fact, the dramatic rise in commodity prices is a source of risk aversion.

Dollar_Requires_a_More_Aggressive_SP_500_Drop_to_Jump_Start_its_Rally_body_Picture_43.png, Dollar Requires a More Aggressive S&P 500 Drop to Jump Start its Rally

We are just starting to see the uncertainty start to bleed into the market’s otherwise consistent outlook of steady returns and rising yields. All it took to drive the most common measure of risk (the S&P 500-based VIX Index) up from its multi-year low was the sharpest weekly decline in over three months. That said, these measure of sentiment is still at extremely tame levels; and the currency market’s measure has barely budged from its own low. Yet, does that mean that all investors are unconcerned with the risks related to pushing asset prices to highs while the potential for yield and returns are not so encouraging? Not really. Looking at the cost of longer-term insurance premiums (the SKEW Index), the risk is obvious.

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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