Risk trends defined the dollar’s rally; and they can likely bring it to a close. Over the past week, the greenback’s status as a primary safe haven and funding currency was still in control; but the underlying currents of sentiment had shifted.
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[B]The Economy and the Credit Market[/B]
Risk trends defined the dollar’s rally; and they can likely bring it to a close. Over the past week, the greenback’s status as a primary safe haven and funding currency was still in control; but the underlying currents of sentiment had shifted. Despite a notable lack of progress from the European Union on the matter of a potential Greek default, the effort to unwind risky positions stalled this week and kept the greenback from overtaking a well-tested seven-month high. The market’s attention is highly fluid; and this could very well be a sign that global investors are moved on to different concerns of return or risk. However, considering the trend for the past month has been a steady decline in risk trends and a steady advance for the dollar over the past two months, it is more likely the case that this is merely a pause before additional concerns bubble to the surface. In the meantime, the US currency itself is finding greater and greater appeal on a purely fundamental basis. With the Euro Zone struggling with a potential structural crisis, the viability of diversifying reserve funds away from the US seems less straightforward. Furthermore, with China having to take active steps to cool its booming economy (to avoid a potential asset bubble) and dimming the global outlook along with it, the United State’s steady recovery looks far more stable and attractive. To top it off, interest rate speculation is starting to find a real foothold. According to the recently released FOMC minutes, the argument for beginning asset sales in the “near future” joins Member Hoenig’s vote to drop the language that rates will be held “exceptionally low” for “an extended period.”
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[B]A Closer Look at Financial and Consumer Conditions[/B]
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Despite the materialization of new and increasingly invasive threats to the stability of the world’s financial markets, risk appetite recovered modestly over the past week. However, considering the limited rebound in optimism to this point, this sense of stability and optimism is most likely temporary. What could potentially revive fear (or even trigger the next surge in risk appetite)? At the top of the list is the focus on Greek’s deficit and the EU’s strategy for stabilizing and isolating the member’s financial troubles before they become systemic. And, while this may be the height of global concerns now, Europe isn’t the only trouble spot. Sovereign credit risk is rising across the globe - and the US is no exception with record breaking deficits. While speculatively-derived assets may be pricing in a V-shaped’ recovery for the US and the rest of the globe; fundamentals and policymakers’ actions have consistently projected a slow and uneven return to growth. In the short-term, the industrialized economy is still showing an exaggerated pace of recovery as we are comparing activity to the severely depressed levels of last year. Turning the focus to the medium-term, government stimulus is starting to be withdrawn; and weak employment, spending and credit conditions will be exposed. What’s more, extraordinary debt levels will encourage spending cuts and tax hikes – further dampening expansion. According to the FOMC minutes, the Fed nonetheless projects 2.8 to 3.5% 2010 growth.
[B]The Financial and Capital Markets[/B]
The markets will always return to a state of normalcy. Whether that relates to a fair fundamental value or a standard level of volatility, the draw of a mean is ever present. This is the course the capital markets have run these past two months and this past week. So far this month, risk appetite has retraced and a fraction of the premium that was built up through the past year has been worked off. However, this has been a relatively steady trend itself; and this past week’s pick up in high-yield assets is a correction itself. And yet, the improvement in commodity and equity benchmarks was relatively mute. This period is therefore more representative of stabilization than it is a true direction of its own. The fundamentals behind the market are less than convincing. Macro economic data supports a muted recovery that is finding temporary support from government stimulus and that critically lacks consumer spending and access to credit. Further down the line, this will weigh on global wealth and temper earnings that have been found a passing boost on inventory replenishing. Add to that news that the largest 11 TARP banks in the US are holding $1.29 trillion in idle cash (the equivalent of 98 cents for every dollar of existing small business loans), and the outlook for higher returns and receding risks is certainly not balanced.
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[B]A Closer Look at Market Conditions[/B]
Looking at the activity of the capital markets this past week alone, it would seem that risk appetite is recovering – though at a relatively tame pace. Broadening our horizons, however, the scope of the week’s improvement is enveloped. Not only is the dominate trend holding to the unwinding of existing risky-positions; but the timely correction is otherwise modest in pace. On the other hand, a true reversal can develop with the right level of conviction across all speculative assets. The benchmarks for equities, commodities and currencies suggest there is a long way to go before the current truly reverses course. And, when it does, expect correlations to intensify. The threats to stability are numerous; and risk premiums certainly don’t reflect the uncertainty. Looking at the more accessible insurance gauges for the capital markets, the CBOE VIX index has retraced quickly from three-month highs and stands at 21.7 percent after six consecutive days of declines. Following a similar pace, volatility levels in the currency market have dropped nearly 10 percent in little more than a week. On the other hand, sovereign debt risk has risen globally, junk bond spreads are widening and credit default premiums have risen more than 30 percent from lows set around the beginning of this year. Should China act again to slow its markets or Greece slip, expect fear to quickly return. [I]Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: <[email protected]>[/I]