Dollar Burdened By Risk, Boosted By Growth Prospects

It has been an active period for the dollar over the past few weeks. Sharp and frequent shifts in risk appetite have undermined the currency’s attempt to find its footing in the market; yet growth forecasts may soon overtake risk as the primary driver.

[B]The Economy and the Credit Market[/B]

         It has been an active period for the dollar over the past few weeks. Sharp and frequent shifts in risk appetite have undermined the currency’s attempt to find its footing in the market; yet growth forecasts may soon overtake risk as the primary driver. There is little doubt at this point that the world’s most liquid currency is still one of the most prominent safe havens - and it will be ready to take on this garb whenever panic sweeps over the market. However, as global financial conditions stabilize and optimism recovers; the market will realize yields across the globe are low across the globe. Instead, forecasts of economic growth will underlie expectations for market stability and rising interest rates (bolstering returns). Where does the US stand in this scale of risk/reward? Today, the OECD lifted its forecasts for economic activity and upped its timeline for the US turn to positive growth. And, though the Fed held its ground on its outlook today at its rate decision while the Treasury Secretary is not ready to withdrawal government support from the markets, the long-term stability it affords may be more valuable.


[B]A Closer Look at Financial and Consumer Conditions[/B]

         Financial stability is still a market state that investors seem to be taking advantage of and yet it is a condition that does not truly exist. The risks of another financial crisis are rife beneath the surface. Aside from the troubles in foreign markets (like potential defaults in Eastern Europe that could easily metastasize into credit problems in the Euro Zone and then the world), the US will still have to confront its own problems. Last week, Standard & Poor’s downgraded 22 banks on the same day that most of the Stress Test banks said that they were repaying significant amounts of their TARP loans. Without this support, another credit seizure could turn into a panic. 





         What should be considered an early sign of growth? There seems to be a general consensus among the markets that smaller contractions in vital indicators and a deceleration in the pace of recession is evidence enough of the inevitable. However, stabilization is not the same thing as positive growth. The US and its global counterparts are still mired in recession – and will likely be so through the end of the year. To put it into perspective, the OECD is predicting a 2.8 percent contraction for the current year before expanding 0.9 percent into next year. With employment expected to rise to over 10 percent and investment permanently stained by this bear market, growth could stagnate for some time.

[B]The Financial and Capital Markets[/B]

         The capital markets have pulled back over the past week. After the G8 meeting, the hopes for an accelerated pace of reinvestment were marred by the policy officials’ decision to defer the rollback of government aid. Since then, confidence has further been shaken by the wave of TARP-recipients announcing their intentions to remove their government safety net. While this hasn’t necessarily weighed the markets down yet, it has eroded long-term confidence. The rebound in risk appetite across the markets has been largely founded on speculation and the diversification of capital back into relatively-risky assets. However, beyond the ‘tentative signs of growth’ many optimists are point at, there have been few fundamentals to support a true recovery. With a tangible turn in momentum amongst equities, commodities and fixed income; sentiment may finally give way to a more rational interpretation of fundamentals. 


[B]A Closer Look at Market Conditions[/B]

         The tentative turn in the US capital markets can be seen across the board. For equities, the benchmark Dow Jones Industrial average has pulled back nearly seven percent from its highs for the year and notable broke a clear rising trend channel that went back to early March. For trends, no pitch was as consistent as crude’s. Yet, this security’s direct link to economic activity has certainly turned its appreciation off before the $75 milestone could be met. Perhaps the most important market to watch going forward will be Treasuries. Not only is government debt attuned to growth and sentiment; but it will also provide a critical look at the abundant financial stimulus in the market.




         Risk has clearly been turned off its steady decline for the past three months. While many of the traditional gauges of risk (the volatility indexes) and more complex (credit default swaps and junk bond premiums) are still near their relative lows; the sidelined momentum is as clear a sign as any. Speculation has to build upon itself; and a pause in optimism could sideline this buoyant sentiment until data truly confirms a recovery in economic growth and returns. Realistically, trouble lingers just beyond the horizon. Earnings shortfalls and write downs for US banks is a strong possibility going forward. However, the next catalyst may be found outside the US boarders.