Sentiment is a fickle thing – especially when it is backed by the full monetary interests of a speculative market. For the dollar’s part, optimism is still a complicated issue. On the one hand, the currency’s function as a safe haven is still an active driver for price action.
The Economy and The Credit Market
[Sentiment is a fickle thing](http://www.dailyfx.com/story/trading_reports/dynamic_carry_trade_basket/Risk_Appetite_and_Carry_Interest_1242949565270.html) – especially when it is backed by the full monetary interests of a speculative market. For the dollar’s part, optimism is still a complicated issue. On the one hand, the currency’s function as a safe haven is still an active driver for price action. The unrequited advance in risk appetite since April has recently met resistance and market participants are one again questioning fundamentals’ role in direction. On the other, the greenback is still the barometer for economic activity the world over. To shake this contradiction in purpose, the US currency requires unmistakable evidence that the world’s largest economy is recovery - and doing so ahead of its global counterparts. This will be a far more difficult charge than simply jumpstarting the economy though. Along the way, the financial markets and budding recovery will have to survive the eventual unwinding of government support (as toxic debt is disseminated back into the market place and TARP loans are repaid). What’s more, global leaders may renew their case for establishing a new reserve currency to deleverage the world’s dependency on the US economy going forward.
A Closer Look at Financial and Consumer Conditions
The financial markets continue to thaw; but the developments are not the underlying improvements that would support a true recovery in credit and growth. Short-term treasury rates are still near record lows, Libor rates are holding near zero and the average 30-year fixed rate mortgage rate is just off its lowest level in years. However, it is important to consider how much of this is due to the market’s natural interest versus the influence of government liquidity. What’s more, will investors readily pick up the slack when governments retract their guarantees? There is still a significant drawdown on investment capital in the wake of the last recession. The eventual transition may be difficult.
For any currency, the [primary case for fundamental strength](http://www.dailyfx.com/story/dailyfx_reports/daily_fundamentals/US_Dollar_Suffers_a_Sharp_1243384840539.html) is based upon the underlying economy’s place in the economic spectrum. Therefore, traders ask themselves whether the US is ahead of the curve in establishing its recovery or destined to see a second wave that confirms the argument that the largest economy is wading through another depression. A critical eye discerns that the ‘green shoots’ that so many market commentators have commented on recently are perhaps optimistic. A slowed pace of economic contraction is not the same as tentative growth. Until growth and employment turn positive, the US economy (and dollar) will struggle.
The Financial and Capital Markets
Looking across the benchmarks for each US asset class, we see signs that we have arrived back to the same levels that preceded the worst of the financial crisis back in October and November. Does that mean that conditions are on par with what they were before the Lehman Brothers collapse and essential-nationalization of AIG? Yes and no. Yes, considering we have gone six months without the threat of another imminent failure among the financial leaders in the US and thereby panic has eased. No, in that the rebound in prices and tempering of volatility is largely the work of temporary government measures. Investors looking for [safety of funds and the hope for yields](http://www.dailyfx.com/story/topheadline/Is_The_Carry_Trade_Recovering__1242960541746.html) will have to consider: regulations will be more stringent going forward; an ongoing recession is naturally weighing returns; and the government’s presence will hamper a recovery as officials will opt for a steady rebound with low volatility. Investors will have to consider how much of the pickup in markets was due to sentiment and how much was true fundamentals.
A Closer Look at Market Conditions
Congestion has set in for a third consecutive week for the capital markets suggesting sentiment may require an economic foundation to sustain its positive trajectory. If that is the case, ‘green shoots’ may not be sufficient to carry the next bull market. In equities, the earnings season is over – though the consensus is still out. Were the relatively mild losses and sometimes positive earnings through the first quarter indicative of a trend towards growth or merely accounting adjustments to carry the corporate world through to the next report when sentiment and fundamentals are more established? Despite a lack of positive growth, commodities were at six month highs.
The improvement in the sense of risk across the market may be just as artificial as the rebound in capital benchmarks. While it is debatable, sentiment has been the primary vehicle of recovery for the markets over the past two months. If this development comes through a settle in fear and panic, then it is genuine as financial shocks have disappeared. On the other hand, if the progression in conditions is through a rise in risk appetite alone; the positive change may be on unstable ground. Volatility indicators for equities, currencies and futures have improved. Credit-centric indicators have also been encouraging. However, panic can easily sweep over these calm markets and undo the good will.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
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