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Dollar’s Rally will Last as Long as Financial Markets Fall Apart

Dollar’s Rally will Last as Long as Financial Markets Fall Apart

2011-08-10 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

Watch What the Fed Watches - Weekly Report

Credit Market

Previous

Current

Change

% Change

Outlook *

DJ Credit Default Swaps

97.293

108.743

11.450

11.77%

Deteriorating

10 Year Junk-Bond Spread

493.71

538.88

45.17

9.15%

Deteriorating

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

0.268

0.281

0.01233

4.60%

Improving

Total Money Market Funds

2682.72

2568.28

-114.44

-4.27%

Improving

Stock Market

Last Week

Current

Change

% Change

Outlook

Dow Jones Industrial Average

11896.44

11008.37

-888.07

-7.47%

Deteriorating

Dow Jones Real Estate Index

223.15

210.03

-13.12

-5.88%

Deteriorating

Dow Jones Financial Index

355.8

313.66

-42.14

-11.84%

Deteriorating

Dow Jones Retail Index

92.33

87.14

-5.19

-5.62%

Deteriorating

S&P Volatility

23.38

38.99

15.61

15.61%

Deteriorating

Put-Call Ratio

2.1

2.64

0.54

0.54%

Deteriorating

Market Breadth (Adv - Dec)

0.3957

0.6624

0.2667

26.67%

Improving

Economic Indicators

Previous

Current

Change

% Change

Outlook

GDP (Annualized)

2.8

1.3

1.3

1.30%

Improving

Mortgage Applications

7.1

21.7

21.7

21.70%

Improving

Initial Jobless Claims

432

400

-32

-7.41%

Improving

Consumer Confidence

57.6

59.5

1.9

3.30%

Improving

ISM Manufacturing

55.3

50.9

-4.4

-7.96%

Deteriorating

ISM Services

53.3

52.7

-0.6

-1.13%

Deteriorating

ISM Services - Employment

54.1

52.5

-1.6

-2.96%

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

The financial markets have been rocked these past few weeks; and the source of this extraordinary volatility seems to be shifting with each leg of the evolving panic. As the headlines change and the focus turns to pure speculative runs (bullish and bearish) we should remember one tenet for the US dollar: the currency is only truly appealing for its liquidity. Many confuse the characteristics of market depth with simple risk appetite / risk aversion. However, there are key differences.

WatchFedWatches_2011-08-10_Dollars_Rally_will_Last_as_Long_as_Financial_Markets_Fall_Apart_body_Picture_1.png, Dollar’s Rally will Last as Long as Financial Markets Fall Apart

Unwinding leveraged positioned (built up through cheap funding) is certainly a factor for the greenback; but that is a balancing effort – not a move to establish new exposure. To truly draw capital into the US, the market needs an overriding need for the unsurpassed liquidity behind the Treasury market and US dollar. Such a shift generally comes during a period of panic; and we have come as close to panic as we have seen since the 2008 Financial Crisis. Sentiment was already plagued by signs that economic activity is cooling, China has been actively pumping the breaks in order to avert a market collapse and the spread of the Euro Zone sovereign funding crisis. This was only further exacerbated by Standard & Poor’s downgrade of the United States’ top credit rating this past Friday. Where these regional financial concerns could previously be seen as unique or isolated; it is increasingly clear to the world that this is a global problem. In reverse order to the 2008 scenario, the economic downturn is preceding a credit crunch; but this next step is pivotal to feeding the capital unwind and dollar rally – especially with the Fed actively weighing the currency down.

A Closer Look at Financial and Consumer Conditions

WatchFedWatches_2011-08-10_Dollars_Rally_will_Last_as_Long_as_Financial_Markets_Fall_Apart_body_Picture_7.png, Dollar’s Rally will Last as Long as Financial Markets Fall Apart

Financial and credit conditions are the tipping point for the world’s markets and economies – just as they were three years ago. We have seen sentiment deteriorate sharply and capital reverse course back to their funding source as expansion cools and the limits to stimulus efforts have come into view. However, the risk aversion effort to this point (despite what it may seem given volatility) has been orderly. When access to funds start to dry up or the other side of a market completely vanishes; then we will see a true panic. That next step will likely come through the banking system. We have recently heard so-far unsubstantiated rumors of funding troubles for Morgan Stanley and Society Generale. When rumor turns to evidence; we will taken the next step.markets are trying to cool capital inflows, and trade wars are arising. Yet, risk appetite has yet to give.

WatchFedWatches_2011-08-10_Dollars_Rally_will_Last_as_Long_as_Financial_Markets_Fall_Apart_body_Picture_10.png, Dollar’s Rally will Last as Long as Financial Markets Fall Apart

Economic activity has been slowing in the US and for the developed world for some time now; but until recently, this downturn was overlooked by a market infatuated with stimulus. With that government support hitting a ceiling and now being backed out; market participants are taking the growth outlook more seriously. This past Friday, the July non-farm impressed few with a modestly better-than-expected print as the now skeptical masses recognize it as too small to work down the inflated jobless rate. Equally disconcerting is the Fed’s assessment of the economy’s prospects. In the statement that accompanied its rate decision, the policy authority noted that activity was weaker than expected while the prospects for jobs, spending and housing were poor. Reality is starting to set in.

The Financial and Capital Markets

After more than two years of steady advance, the US capital markets are finally starting to falter under their own weight. It should be said that the rally that began for equities began in the first quarter of 2009 – soon after the worst financial crisis and economic recession in decades drove much of the speculative ranks out of the market. The natural return of capital after panic passed and the involvement of the US and world governments to raise activity levels and asset prices contributed to the consistent advance that countered the disorderly decline.

WatchFedWatches_2011-08-10_Dollars_Rally_will_Last_as_Long_as_Financial_Markets_Fall_Apart_body_Picture_4.png, Dollar’s Rally will Last as Long as Financial Markets Fall Apart

Yet, few of the factors that contributed to the recovery of the markets could have been labeled permanent. And now, the traders are paying for over-extending themselves on temporary factors. The economic slowdown is the most pervasive trouble for the markets as it is the foundation for return. However, the true hit to the risk / reward balance can be traced to the collapse in confidence for stimulus as a counterbalance. This week, the Fed decided to stay away from announcing a QE3 program (there is a loud argument that the second iteration didn’t produce lasting results); but the central bank did explicitly warn that rates would remain ‘exceptionally low’ through 2013. Extremely low rates four at least two more years would help feed speculation – if investors believed the US efforts alone could quell what is clearly a global and deeply-rooted issue.

A Closer Look at Market Conditions

WatchFedWatches_2011-08-10_Dollars_Rally_will_Last_as_Long_as_Financial_Markets_Fall_Apart_body_Picture_13.png, Dollar’s Rally will Last as Long as Financial Markets Fall Apart

The capital benchmarks have shown the outright fear that have overwhelmed the speculative ranks these past few weeks. Orderly selling is one thing; but severity of the unwinding effort we have seen more accurately reflects a level of panic that has led to liquidity and funding problems in the past. What should really hit home from the individual performance in equities, bond yields and commodities is the synced direction and momentum behind these markets. Correlations tighten up when momentum is high and the fundamental drive behind the effort is unanimous across asset class. Easier to interpret; but ultimately more concerning.

WatchFedWatches_2011-08-10_Dollars_Rally_will_Last_as_Long_as_Financial_Markets_Fall_Apart_body_Picture_16.png, Dollar’s Rally will Last as Long as Financial Markets Fall Apart

Panic selling has led to a clear jump in the traditional volatility readings. Yet, the VIX, CVIX and commodity volatility indexes are still not ideal barometers for market uncertainty – and certainly not for direction. The short-fall is obvious when we note that the S&P 500-based VIX dropped sharply after the underlying index saw a dramatic rally to follow its biggest drop in years. Direction aside, this was a very volatile move and should have maintained the derivatives reading. So, instead, we look to the collective performance of credit default swaps, liquidity measures, short-term rates and other readings of stability. And, in this general overview we find reason for concern – as panic is visible in all of the measures.

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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