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Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

2011-07-21 09:03:00
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

96.700

96.180

-0.520

-0.54%

Improving

10 Year Junk-Bond Spread

507.44

488.54

-18.9

-3.72%

Improving

Credit Card Delinquencies

3.09

3

-0.09

-0.09%

Improving

Mortgage Delinquencies

8.25

8.32

0.07

0.07%

Deteriorating

US 3 Month Libor Rate

0.249

0.253

0.00375

1.50%

Improving

Total Money Market Funds

2741.92

2696.33

-45.59

-1.66%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

12491.61

12595.45

103.84

0.83%

Improving

Dow Jones Real Estate Index

237.22

240.59

3.37

1.42%

Improving

Dow Jones Financial Index

367.83

366.76

-1.07

-0.29%

Deteriorating

Dow Jones Retail Index

97.83

99.37

1.54

1.57%

Improving

S&P Volatility

19.91

18.93

-0.98

-0.98%

Improving

Put-Call Ratio

2.24

1.63

-0.61

-0.61%

Improving

Market Breadth (Adv - Dec)

0.4138

0.3932

-0.0206

-2.06%

Deteriorating

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

1.9

1.9

1.90%

Improving

Mortgage Applications

-5.1

15.5

15.5

15.50%

Improving

Initial Jobless Claims

430

405

-25

-5.81%

Improving

Consumer Confidence (UMich)

71.5

63.8

-7.7

-10.77%

Deteriorating

ISM Manufacturing

53.5

55.3

1.8

3.36%

Improving

ISM Services

54.6

53.3

-1.3

-2.38%

Deteriorating

ISM Services - Employment

54

54.1

0.1

0.19%

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

Traders_Unsure_of_Dollar_Safe_Haven_Status_Under_Deficit_Focus_body_Picture_1.png, Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

We haven’t had a clear bearing on sentiment trends for a few weeks; and the absence of this underlying driver has left the dollar high and dry. Yet, even if we did have a clear bearing on risk appetite, the greenback would still struggle to take up its traditional role of the market’s most liquid safe haven. The disconnect is the drawn out debate over how to resolve the United States fast-approaching default. Raising the legal ceiling on the country’s ballooning debt holdings is a common enough practice; but politicians have taken a stand with this iteration – demanding that a long-term solution be put into place to finally turn the growing deficit from its trend of consistent expansion. Looking ahead, it is highly likely that a resolution (whether it be just a boost in the ceiling or the adoption of legislation to enforce efforts to balance the budget) will be adopted – the consequences of the alternative are simply too imposing to the financial system and the US economy. The challenge is to determine what happens after this roadblock is passed. The implications for risk appetite trends are the first consideration. With the threat of reserve asset holdings (Treasuries) suddenly confronting a downgrade evaporating, the capital markets may take it as a cue to rally. And, though the dollar’s safe haven status would improve; it probably wouldn’t offer enough of a boost to offset the risk implications. Furthermore, when the deficit issue is surpassed, the need for safety-of-funds will have to be leveraged to drive an active bid for the US dollar. One step at a time though.

A Closer Look at Financial and Consumer Conditions

Traders_Unsure_of_Dollar_Safe_Haven_Status_Under_Deficit_Focus_body_Picture_7.png, Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

Financial stability is currently the primary concern for the global markets. The easiest to grasp threat at the moment is the European sovereign debt crisis. The market is no longer blind to the broad implications of this issue. What began in Greece spread to Ireland and Portugal without much trouble; and the contagion is now showing signs with Spain and Italy. As it becomes more of a Euro-Zone problem; the global implications will become more obvious (we don’t have to look back far enough to see the impact that the ‘US-borne’ subprime crisis had globally). Yet, despite how much press the Euro crisis is garnering; the US deficit trouble is far more pervasive. The US Treasury note is still the primary risk-free asset for the world. If that changes, valuation itself changes.

Traders_Unsure_of_Dollar_Safe_Haven_Status_Under_Deficit_Focus_body_Picture_10.png, Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

The event calendar has fully undermined the general assessment of health for the US economy this week. From a big-picture perspective, however, this slow down has already been priced in by the rates and investment capital. Notables on the docket were the weak performance in June retail sales and unexpectedly sharp drop from the University of Michigan consumer confidence survey (measures of spending); a temperate reading for industrial production (the backbone of US growth in the recovery period); and stubborn growth in inflation figures. All told, these are developments to curb expansion and make monetary/fiscal policy efforts more complicated. Looking ahead, the next headline release is the upcoming 2Q GDP release for the US. Confirmation of slowdown is enough to deliver a hit to risk trends.

The Financial and Capital Markets

Traders_Unsure_of_Dollar_Safe_Haven_Status_Under_Deficit_Focus_body_Picture_4.png, Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

A lot of smoke but little fire – that is the cliché we should use to describe the market over the past two weeks. We have seen an inordinate amount of volatility and even a few sharp runs. However, the turnover and strong drives have dried up just when we come to the point where the market has to make a decision on a meaningful trend. Developing a meaningful bearing seems so difficult because it is. Currently, the market is confronted with a series of prominent doubts (the spread of the European crisis, the US deficit limit, the slowdown in global growth, changes to stimulus regimes, etc) and the possibility that these catalysts can fall either way is encouraging many to stand pat on their current asset and cash holdings. This is even more troubling as it isn’t even clear what constitutes a reliable safe haven. For investors, these thematic issues are always buzzing in the background; but US traders have to be a little more proactive in addressing the implications of the second quarter earnings season. A few years of recovery-led growth, cost cutting and accounting gimmicks is finally starting to wear thin. The true salt of business sector health is starting to show through in income figures. The financial sector is particularly interesting as they are central figures in the liquidity scheme. That said, Goldman Sachs, Bank of America, Citi and others are having to resort to working down loan loss reserves (back up capital) to keep their earnings above expectations.

A Closer Look at Market Conditions

Traders_Unsure_of_Dollar_Safe_Haven_Status_Under_Deficit_Focus_body_Picture_13.png, Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

We have seen some dramatic swings in some of the benchmark assets these past few months; but a true trend has been notable absent through all of this. It is difficult to encourage a wholesale bid when prices are already so rich; but then again, those sitting on profit aren’t necessarily willing to unwind until it is clear that the government is ready to dump its position (unwind stimulus). In the meantime, the excess volatility has started to cut into correlations and leads to difficulty in using cross-market shifts to guide trades. This is a direct result of the lack of theme behind the market. Without a common driver; we are left to drift.

Traders_Unsure_of_Dollar_Safe_Haven_Status_Under_Deficit_Focus_body_Picture_16.png, Traders Unsure of Dollar Safe Haven Status Under Deficit Focus

Once again, we need to look in the right places to get a true bead on risk. If we were to look at the traditional volatility indexes (VIX, CVIX, OVX, SKEW, etc); it would seem that the markets are stable enough to revive their steady advance. However, the implied volatility figures through options can be somewhat misleading as it is only a reflection of whether the market wants to buy insurance – we have seen the market spurn protection when it is needed to many times before. Instead, we should be looking at short-term lending rates, demand for liquidity (the difference between forward rate agreements and Libor) and credit default premiums. These are measures of risk at the very foundations of liquidity.

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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