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Dollar Traders Weigh Interest Rate Expectations against Market Stability

Dollar Traders Weigh Interest Rate Expectations against Market Stability

2011-03-04 20:42:00
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

83.100

82.528

-0.572

-0.69%

Improving

10 Year Junk-Bond Spread

454.65

456.60

1.95

0.43%

Deteriorating

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

0.311

0.310

-0.001

-0.32%

Deteriorating

Total Money Market Funds

2740.41

2751.34

10.93

0.40%

Deteriorating

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

12130.45

12094.16

-36.29

-0.30%

Deteriorating

Dow Jones Real Estate Index

229.67

226.61

-3.06

-1.33%

Deteriorating

Dow Jones Financial Index

389.24

383.71

-5.53

-1.42%

Deteriorating

Dow Jones Retail Index

94.23

92.94

-1.29

-1.37%

Deteriorating

S&P Volatility

19.22

20.01

0.79

0.79%

Deteriorating

Put-Call Ratio

2.59

1.6

-0.99

-0.99%

Improving

Market Breadth (Adv - Dec)

0.4703

0.5610

0.0907

9.07%

Improving

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

2.8

2.8

2.80%

Improving

Mortgage Applications

13.2

-6.5

-6.5

-6.50%

Deteriorating

Initial Jobless Claims

457

368

-89

-19.47%

Improving

Consumer Confidence

64.8

70.4

5.6

8.64%

Improving

ISM Manufacturing

60.8

61.4

0.6

0.99%

Improving

ISM Services

59.4

59.7

0.3

0.51%

Improving

ISM Services - Employment

54.5

55.6

1.1

2.02%

Improving

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_Traders_Interest_Rate_Expectations_against_Market_Stability_body_Picture_1.png, Dollar Traders Weigh Interest Rate Expectations against Market Stability

For all intents and purposes, the US dollar hasn’t seen a meaningful shift in its bearings or activity level through the past week. That makes sense considering the backdrop for risk trends are still wobbling on the verge of reversal and Fed-based yield expectations are still hovering around a 40 basis point, 12 month forecast. Yet, given everything in the FX market is relative, the currency has seen its value undermined by considerable inflation in interest rate potential from a few key counterparts. The most influence development of the past week happens to reside outside the purview of US fundamentals. After announcing the benchmark lending rate would be held unchanged at 1.00 percent, the European Central Bank offered the market the clearest warning of an impending rate shift that the market has seen in more than two years. What does this mean to the dollar? As the benchmark counterpart to the shared currency, the euro’s strength naturally draws capital away from the greenback. Furthermore, the active step towards a hawkish policy regime increases the gap between the dollar and other core currencies for return potential (via rates and capital gains that attempt to price the move in ahead of time). Currently, the 12-month outlook for the Fed benchmark rate is pricing in a meager 40 bps. In contrast, the ECB is expected to tack on 122 bps in the same period. In the months ahead, the interest rate debate will certainly pick up as the Fed closes on the end of QE2 program and the ECB puts up its first hike. In the meantime, we should not turn a blind eye to underlying sentiment trends.

A Closer Look at Financial and Consumer Conditions

Dollar_Traders_Interest_Rate_Expectations_against_Market_Stability_body_Picture_10.png, Dollar Traders Weigh Interest Rate Expectations against Market Stability

Financial market stress is at its highest levels since before the Board of Governors announced they would halt stimulus withdrawal and would in fact add to it with a $600 billion Treasury buying program. We have yet to see panic spread across the speculative population; but there are credible developments that should put every trader on alert. In addition to record food prices, China’s efforts to curb growth, growing strains between austerity and growth efforts and unrest in the middle east driving energy prices to painful levels; capital imbalances may start shifting funds from high-yield emerging markets to the rising return in certain advanced economies. While this is a pursuit of return, it is also an assessment of risk - giving up a little yield for a sense of stability.

Dollar_Traders_Interest_Rate_Expectations_against_Market_Stability_body_Picture_13.png, Dollar Traders Weigh Interest Rate Expectations against Market Stability

Over the past few weeks, we have seen a range of indicators offering moderate deviations from expectations – both positive and negative. However, the underlying trends seem to show a consistency in the economy’s steady recovery. It can be difficult to separate one’s self from the volatility and timeliness of regularly released data. However, it isn’t the individual readings that define the bearing of the economy but rather the general trends. That said, we note that the second reading of 4Q GDP would show a negative revision; but the 2.8 percent annualized pace of growth was nonetheless a stark improvement from the previous year and was further supported by key components of the economy (personal spending, investment, etc). The same can be said about the NFPs figure. A slow but seemingly lasting recovery in jobs.

The Financial and Capital Markets

Dollar_Traders_Interest_Rate_Expectations_against_Market_Stability_body_x0000_s1030.png, Dollar Traders Weigh Interest Rate Expectations against Market Stability

There is a critical fracture in the capital markets. There are two basic means for value: supply and demand or speculative expectations. For much of the past six months, funds have steadily been siphoned into risky positions, boosted by the outlook for capital gains and rising yields. Yet, in the background, fundamental contention was developing grounding expectations for revenues, market stability, rate expansion and other critical conditions of the standard risk-reward assessment that establishes the value for a particular security or the market at large. The charade of gains leading to more gains, however, may have been broken with the sudden shock of supply and demand concerns in the commodity market. This follows the bull trend that preceded this new leg; but the velocity of price action and reasoning this activity has changed. It is this increased volatility that is starting to undermine the unrealistic projections for returns and further leading market participants to reconsider fair values with the global economy coming under the strains of political and natural resource concerns. We should not forget that the world is still recovering from the worst recession in generations and stimulus is still an indelible component of current conditions. Eventually, support has to be withdrawn; and the market will have to stand on its own convictions and optimism.

A Closer Look at Market Conditions

Dollar_Traders_Interest_Rate_Expectations_against_Market_Stability_body_Picture_4.png, Dollar Traders Weigh Interest Rate Expectations against Market Stability

For performance, it is difficult to doubt the bullish trend that has dominated the headlines and charts for more than six months. However, the stability of these gains has been shaken. Volatility in the commodities market (most recently crude, though agricultural and industrial metals have seen remarkable rallies as well) has shattered the habitual approach of simply reinvesting capital into steadily rising markets. With this volatility, we have seen the first serious deviation from the long-standing bull trend for the S&P 500 and Dow develop. This has yet to evolve into a true profit-taking, positioning unwinding effort; but it will eventually.

Dollar_Traders_Interest_Rate_Expectations_against_Market_Stability_body_Picture_7.png, Dollar Traders Weigh Interest Rate Expectations against Market Stability

Last week, we introduced the Skew Index as a means for better reflecting on the uncertainty that does exist in the markets. Rather than looking at risk premium priced into the very short-term (which investors are willing to absorb as they have grown a dependency on stimulus and expectations for others to feed additional money into the system); this particular indicator measures the cost of protection covering just a day ahead out to more than a year in the future. The gap here furthers the argument that speculative expectations are projecting impractical levels of return and consistency; and perhaps that there is a distortion in participation. It is the highly speculative and stimulus accessing participants that are feeding these trends.

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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