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Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

2011-05-06 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

89.498

89.753

0.254

0.28%

Deteriorating

10 Year Junk-Bond Spread

453.76

444.85

-8.91

-1.96%

Improving

Credit Card Delinquencies

3.76

3.53

-0.23

-0.23%

Improving

Mortgage Delinquencies

9.13

8.22

-0.91

-0.91%

Improving

US 3 Month Libor Rate

0.273

0.268

-0.0045

-1.65%

Deteriorating

Total Money Market Funds

2731.79

2727.04

-4.75

-0.17%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

12763.31

12673.32

-89.99

-0.71%

Deteriorating

Dow Jones Real Estate Index

242.27

239.11

-3.16

-1.30%

Deteriorating

Dow Jones Financial Index

388.23

384.58

-3.65

-0.94%

Deteriorating

Dow Jones Retail Index

99.47

98.11

-1.36

-1.37%

Deteriorating

S&P Volatility

14.62

17.29

2.67

2.67%

Deteriorating

Put-Call Ratio

1.21

2.08

0.87

0.87%

Deteriorating

Market Breadth (Adv - Dec)

0.6580

0.5431

-0.1149

-11.49%

Deteriorating

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

1.8

1.8

1.80%

Improving

Mortgage Applications

-5.6

4

4

4.00%

Improving

Initial Jobless Claims

392

474

82

20.92%

Deteriorating

Consumer Confidence

63.8

65.4

1.6

2.51%

Improving

ISM Manufacturing

61.2

60.4

-0.8

-1.31%

Deteriorating

ISM Services

57.3

52.8

-4.5

-7.85%

Deteriorating

ISM Services - Employment

53.7

51.9

-1.8

-3.35%

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_Rally_Looks_for_Fuel_Can_NFPs_Carry_the_Bull_Run_body_Picture_1.png, Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

It seems that the dollar has put in for a critical reversal just ahead of the market’s most market-moving economic release. However, it is important to push back our speculative appetites to review the market with an objective eye towards fundamentals and capital flows. The first thing we need to appreciate is that regardless of the follow through on the greenback’s recent appreciation, it is still a tentative move. One consideration that should curb bulls’ enthusiasm is that the currency could be considered over-extended following a two-week plunge to near-three year lows having already spent the past four months in a consistent decline. Profit taking is a natural occurrence even in a consistent trend. Taking stock of the specific catalysts to this particular turn in the dollar; we should gauge the influence of its chief drivers: relative growth; risk appetite trends and yield expectations. Economic activity is well-integrated into the market’s forecasts; and there are few timely updates that can dramatically change the outlook. Yield expectations can carry the dollar’s recovery the furthest; but the FOMC statement this past weekend pushed back the reasonable possibility for gaining clarity on changes to monetary policy until at least the QE2 expiration next month. Then there is risk appetite. Capital markets have seen a significant leg down recently; but the S&P 500’s losses have so far been modest. Any one of these drivers (and certainly all of them together) could bolster the dollar’s position; but without the support, this tentative run would quickly stall. So, the question we should ask is whether NFPs caters to these drivers in a meaningful way. It’s unlikely.

A Closer Look at Financial and Consumer Conditions

Dollar_Rally_Looks_for_Fuel_Can_NFPs_Carry_the_Bull_Run_body_Picture_7.png, Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

Assessing the health of the financial markets, we should look beyond the steady trends of recent months as well as the recent spike in volatility that has shaken the US dollar back to prominence. A fair appraisal of stability should not just be based on price action but the fundamentals behind the market as well. For a while we have seen the value of assets rise consistently while the reasonable outlook for yield (return) has held steady or declined and the risks associated to holding the position have risen proportionately. Such an imbalance posses a significant risk – though it can be ignored for quite a long time as the masses growth comfortable with the trend. This is what economist John Maynard Keynes was referring to when he said “markets can remain irrational longer than you or I can remain solvent.

Dollar_Rally_Looks_for_Fuel_Can_NFPs_Carry_the_Bull_Run_body_Picture_10.png, Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

Having already been offered the FOMC’s take on monetary policy going forward, the market is once again taking the slow approach to gauging the same drivers that guide the group’s efforts. Following a dual mandate for stable price growth and ‘full’ employment, we know more or less what to look at. Knowing that the Fed continues to write off headline inflation until it hits oppressive levels; we are left to follow the labor market. With the NFPs report, we have seen the trend slowly turn from dramatic net job losses to modest gains; but no single monthly increase will immediately pull the unemployment rate down from the 8.8 percent standing to the 5 to 6 percent range that the central bank is seen targeting. That is why the market’s favorite economic indicator hasn’t been able to drive larger moves this past year.

The Financial and Capital Markets

Dollar_Rally_Looks_for_Fuel_Can_NFPs_Carry_the_Bull_Run_body_Picture_4.png, Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

We have seen a progressive shift in performance for the capital markets. Through the end of February, there was a steady build in ‘risky’ positioning that was riding the wave of stimulus that the Fed had pumped into the market back in November. Yet, momentum was already running thin when the Japanese earthquake tested the stability and confidence behind this exposure. And, while this particular event wouldn’t spark a lasting reversal; it was enough to cripple bulls permanently so that they can’t simply carry an uncontested trend. Uncertainty in the middle east, US banks having to reduce loan loss reserves to maintain strong earnings, consistently moderate-level economic releases and expensive levels for assets are all starting to take their toll. When a true bear phase steps in, the fuel will be provided by sentiment itself. Investors will see the balance of potential risk and return as too precarious for them to simply maintain the buy-and-hold strategy that has worked so well since the second quarter of 2009. In the meantime, a catalyst will be critical factor in securing this change. The NFPs figure has limited scope in playing this role; but added to speculation surrounding the Euro area’s financial trouble and emerging market capital collapse; it could help push us there.

A Closer Look at Market Conditions

Dollar_Rally_Looks_for_Fuel_Can_NFPs_Carry_the_Bull_Run_body_Picture_16.png, Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

We have seen a very convincing drop in the broader capital markets; but the pace between the different asset classes has been very different. Most aggressive are the declines seen in commodities. The move began with silver which had run a historic rally that doubled its price in a matter of months. Recognizing speculators’ hand in this drive, a consistent series of margin hikes to trade the metal lead to an abrupt drop. Noting the success of this move, traders in gold and oil feared the same; and let the dollar’s rally encourage a cover. Yet, the S&P 500 has shown far more restraint. Stimulus is still prominent here; and increasing costs is more difficult.

Dollar_Rally_Looks_for_Fuel_Can_NFPs_Carry_the_Bull_Run_body_Picture_19.png, Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?

Volatility has jumped sharply in just the past week. The dramatic activity in the underlying markets is the reason for this aggressive level of activity; but we should sort out whether this was a temporary reaction to just the intervention of regulators to changing the functioning of the market (raising margin requirements) or whether this is a lasting drive as the market finally discounts for existing risks. There are plenty of fundamental uncertainties behind the market; but it is the buildup in asset prices that provides the real problem. Having pumped up the markets so high and unbalancing the positioning to a heavily long bearing leaves little reprieve should sentiment change. It is easy to have a sharp decline; while a dramatic rally is unlikely.

Written by: John Kicklighter, Senior 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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