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Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

2011-05-25 23:00:00
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

88.641

91.500

2.859

3.23%

Deteriorating

10 Year Junk-Bond Spread

438.31

450.09

11.78

2.69%

Deteriorating

Credit Card Delinquencies

3.53

3.29

-0.24

-0.24%

Improving

Mortgage Delinquencies

8.25

8.32

0.07

0.07%

Deteriorating

US 3 Month Libor Rate

0.260

0.255

-0.0055

-2.12%

Deteriorating

Total Money Market Funds

2746.21

2738.34

-7.87

-0.29%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

12560.18

12384.56

-175.62

-1.40%

Deteriorating

Dow Jones Real Estate Index

237.83

234.99

-2.84

-1.19%

Deteriorating

Dow Jones Financial Index

383.13

373.26

-9.87

-2.58%

Deteriorating

Dow Jones Retail Index

97.64

96.48

-1.16

-1.19%

Deteriorating

S&P Volatility

16.23

17.36

1.13

1.13%

Deteriorating

Put-Call Ratio

1.89

1.84

-0.05

-0.05%

Improving

Market Breadth (Adv - Dec)

0.4029

0.5042

0.1013

10.13%

Improving

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

1.8

1.8

1.80%

Improving

Mortgage Applications

7.8

1.1

1.1

1.10%

Improving

Initial Jobless Claims

416

409

-7

-1.68%

Improving

Consumer Confidence

69.8

72.4

2.6

3.72%

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_hits_two_month_highs_but_rate_outlook_still_critically_missing_body_Picture_1.png, Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

The US dollar has put in for substantial gains through May. From a multi-year low set on the first active trading day of the month, the Dow Jones FXCM US Dollar Index has rallied as much as 4.5 percent. The same strength is clearly visible across the individual majors as well – from the high yield units to financial troubled currencies to fellow safe havens. This common strength would suggest an inherent (self-generating) strength; but there is reason to be dubious about a lasting bull trend for the greenback. When we take a closer look at the fundamentals behind this market, it isn’t a stretch to link performance to risk appetite trends. Looking to correlations and connections, we see that the S&P 500 (a good benchmark for investor sentiment) has stumbled over the same period that the index has stumbled over the same period the dollar has appreciated. Given the greater burden for the currency to overtake its higher yielding currencies; the link isn’t difficult to make. However, there is also likely a restrained influence here through a changing interest rate outlook. We have seen a number of Fed policy officials take a hawkish turn in their commentary (most recently Plosser); but there is still a long way before the central bank starts to drain its stimulus and comes to that first rate hike. Playing to the safe haven appeal of the greenback has proven in the past to be a temporary booster. If the dollar is to turn this correction into a true reversal; we will need to see its ‘return’ facet improve.

A Closer Look at Financial and Consumer Conditions

Dollar_hits_two_month_highs_but_rate_outlook_still_critically_missing_body_Picture_7.png, Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

Financial stability is a prominent concern for the global markets right now; but the most accessible threat is the situation in Europe. There are varying opinions for what kind of backlash a painful resolution to this burden will have for the US economy and its currency; but a financial crisis for this region (collectively the largest economy in the world) would almost certainly create troubled trading conditions across the rest of the world. And yet, the Euro Zone sovereign debt crisis isn’t the only problem we should be keeping our eyes on. Looking closer to home, there are still considerable headwinds facing US growth and returns. The end of the QE2 stimulus program is a glaring point of uncertainty. The Fed will likely maintain its holdings for a few months, but it will eventual drain liquidity.

Dollar_hits_two_month_highs_but_rate_outlook_still_critically_missing_body_Picture_10.png, Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

The US economy has shown a few positive economic highlights over the past week. On the reserved side, we have seen durable goods drop by the most in six weeks (the manufacturing sector has been a particular source of growth in the United States’ recovery) while the housing sector has shown a weak effort at revival as its drags along at its worst performance levels in weeks. On the other hand, there have been a few highlights. Most notable has been the positive outlook from monetary policy officials. Most Fed members now see expansion at an either moderate or accelerating pace. Furthermore, the FOMC minutes from the last rate decision showed that the group feels conditions are encouraging enough that they can start plotting the withdrawal of stimulus – a clear signal of optimism.

The Financial and Capital Markets

Dollar_hits_two_month_highs_but_rate_outlook_still_critically_missing_body_Picture_4.png, Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

Capital markets have shown a significant slide this month in value. It would be a stretch at this point to label this correction a clear sign that underlying sentiment has reversed course; but it is certainly a step that can drive the market to that conclusion. The catalysts behind this souring of optimism are many and varied; but pointing to the specific trigger is difficult to do. The prevalence of uncertain factors in the global markets ensured that a turn was inevitable; but the timing was a prospect for when speculative momentum would finally capitulate and investors began to doubt their ‘rich’ positions. If we were to refer to the upcoming economic docket, there are many indicators that could give a meaningful view of economic health. Yet, the investing community is currently not hanging on the month-to-month changes in specific sectors of the US economy. More elemental themes are taking the reins on investment decisions. For that reason, there is significant interest in Europe’s handling of its Greece’s troubles; but there is also a countdown to the end of the Fed’s stimulus regime. For the dollar, a withdrawal of support for the economy will mean a drop in the supply of the currency. Alternatively, pulling out stimulus is equivalent to rolling back the safety net for equities and other asset classes. Are the capital markets really stable enough to stand on their own? Are they strong enough to justify current levels sans a government buyer?

A Closer Look at Market Conditions

Dollar_hits_two_month_highs_but_rate_outlook_still_critically_missing_body_Picture_16.png, Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

From the market benchmarks, we can sense the uncertainty from bulls. They haven’t necessarily given up on the speculative climb; but they have throttled back on their bid. For the benchmark S&P 500 and Dow Jones Industrial Average indexes, May has been a corrective month. Yet, the pullback occurs from near-three year highs; so we aren’t in too bearish of territory just yet. From the commodity group, we have seen a sharp drop in speculative interest measured in COT figures; and price on assets like oil has certainly suffered for it. Here, we have seen the pain ease though and crude has actually shown its desire to bounce this week.

Dollar_hits_two_month_highs_but_rate_outlook_still_critically_missing_body_Picture_19.png, Dollar Hits Two Month Highs but Rate Outlook Still Critically Missing

As seems to be the trend nowadays, the prevalence of fundamental fears and the recent correction in price doesn’t seem to have troubled investors too much. The cost of insurance against major market declines (which we read in implied volatility through options) shows premiums are still very low. The equities-based VIX is still bouncing along a three month low, the FX-derived CVIX is still generally trending lower from its mid-2010 peak and both the CBOE’s gold and oil volatility readings have dropped this past month. That said, we know the market to under-appreciate the presence of risk in favor of higher return. We just need to establish a timetable. That said, we will keep an eye on short-term interest rate costs.

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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