We’ve seen the dollar endure significant volatility over the past week; but not much direction has come out of it. From pulling itself up from the next leg of a long-term decline to fading its aggressive recovery, the market’s most liquid currency is clearly at the mercy of fundamental uncertainty. As has been the case for many months, the market is having to weigh two significant fundamental themes and each is taking a different path.
The Economy and the Credit Market
We’ve seen the dollar endure significant volatility over the past week; but not much direction has come out of it. From pulling itself up from the next leg of a long-term decline to fading its aggressive recovery, the market’s most liquid currency is clearly [at the mercy of fundamental uncertainty](http://www.dailyfx.com/story/currency/eur_fundamentals/Does_the_Dollar_s_NFP_Rally_1249762476412.html). As has been the case for many months, the market is having to weigh two significant fundamental themes and each is taking a different path. First is the dollar’s safe haven influence. This has clearly diminished with time – though the general bias in still in place. On this front, the statement with today’s [FOMC rate decision](http://www.dailyfx.com/story/topheadline/Fed_May_Disappoint_Many_Dollar1250100524998.html) helped to curb the fundamental link that defined the worst of the financial crisis. Despite no change to the benchmark lending rate or the debt purchase programs (Treasury or Agency), the central bank would put a time frame on the purchase of government debt to October – just beyond the September meeting to buy the policy authority time. The other prominent driver for the currency is the pace of the US recovery relative to its major counterparts. Most of the world’s largest nations are on track to breech the positive growth barrier and then stagnate for a time from there. However, the market should concentrate less on deficits in the short-term and instead focus on short-term signs of genuine recovery – like the unexpected, downtick in the July unemployment rate.
A Closer Look at Financial and Consumer Conditions
For the financial markets, the government and central bank maintain their struggle to encourage lending to the consumer level. The Treasury’s bailouts and Fed’s liquidity are keeping the banks stabilized; but the trickle through in credit to the American consumer can’t keep up with rising unemployment, falling wages and deflated sentiment. Officials have so far, politely asked those taking advantage of the stability that tax payer money has secured to spread the wealth; however, this is making little headway as banks instead try to bolster reserves and stabilize returns. Naturally, credit for investment has also run relatively dry. However, we are still seeing a shift in funds away from money markets to more speculative endeavors.
Economic readings over the past week have been promising. Unlike the advanced reading of 2Q GDP that was released the week before, last Friday’s labor data was equipped with tangible improvement. While still far from a much-needed return to trend of job growth, the drop in [July’s headline non-farm payroll (NFP) reading](http://www.dailyfx.com/story/topheadline/U_S__Job_Losses_Slowed__Unemployment_1249650854480.html) was much smaller than expected at a 247,000 contraction. However, the real source of optimism was the downtick in the jobless rate to 9.4 percent. So, while the unemployment rate is still likely to climb with time (a point President Obama has cautioned on), this step back suggests the pace of decline is not so severe that it will be a straight run. Now they just need this to translate into consumer spending.
The Financial and Capital Markets
The Financial markets have been just as choppy as the dollar; but there a better sense of direction to come out of those asset classes that are more abashedly correlated to risk appetite. Without the attachment to a safe haven title (Treasuries are perhaps an exception on this point), investor interest can more readily reflect the market’s outlook for expected return and economic recovery. Friday’s NFP report was an obvious booster for speculative interests; but like the GDP numbers, this indicator needed to be taken into context. While the contraction in payrolls is slowing, it has been nonetheless a steady trend of 19 consecutive months of net losses that has dampened American’s will and ability to spend. This has an obvious and direct impact on domestic consumption; and foreign demand is in an even worse state given the widespread recession and the protectionist lean many countries are taking to get their own ship in order before helping anyone else. Despite this disappointing fundamental picture, capital is still finding its way back into the market and the traditional assets are only too-happy to accommodate. The only question now is whether the influx of capital can speculative interests buoyant long enough for actual fundamentals to catch up.
A Closer Look at Market Conditions
There is clearly hesitation in the capital markets. Despite the better-than-expected, headline growth and labor indicators these past two weeks, neither financial assets nor physical goods have risen substantially. For stocks, the Dow has been constrained to a range (whose ceiling marks the high for the year) following a near 16.5 percent rally from July’s lows. Earnings are the primary concern for firms; and the disappointing view of consumer spending and capital investment clearly hurts the bottom line. The same issues prevent a genuine period of expansion (not just a tip into positive growth) for natural demand for commodities.
[Volatility has ticked higher](http://www.dailyfx.com/story/strategy_pieces/weekly_range/Forex_Strategy_Outlook__US_Dollar_1249915479515.html) these past few weeks with the big-name economic indicators; but this is not a major disruption of the general trend in risk appetite. Risk premium in investment-grade assets and default protection continues its steady deflation as the government support net has led banks and large investors to believe there is a low risk of another market-wide credit or financial seizure. However, core problems still exist. Investment capital from the consumer side (a large portion of net wealth) is still shrinking with the economy. What’s more, there is still a glut of toxic debt in the markets that seems to be largely ignored. If not answered, these issues could eventually destabilize markets.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>.