Risk appetite has seen a sharp revival this week; and the swell has had a clear, detrimental impact on the US dollar. However, this pickup in sentiment is likely to crest soon. The question Forex traders should be asking is whether the greenback will be ready to take the reins should investment optimism once again levels off.
The Economy and the Credit Market
Risk appetite has seen a sharp revival this week; and the swell has had a clear, detrimental impact on the US dollar. However, this pickup in sentiment is likely to crest soon. The question Forex traders should be asking is whether the [greenback will be ready to take the reins](http://www.dailyfx.com/story/currency/eur_fundamentals/US_Dollar_Looking_For_a_1247272881119.html) should investment optimism once again levels off. To answer this question, we must first understand the source of the recent bullish drive. There have been minor improvements in various economic indicators and forecasts for some weeks (including the projections from the G8 summit last week); yet these indicators have hardly raised prospects to an impending push into positive growth. Instead, market participants are likely finding their buoyancy from the start of 2Q corporate earnings season. So far, Blue chips like Johnson & Johnson, Intel and Goldman Sachs have supported signs of a broader recovery. However, this rise in revenue isn’t surprising – especially with government aid still in place. When blatant risk appetite finally settles, currencies will once again be pitted against each other for economic and financial stability. With the upgrade in growth forecasts from the FOMC today and IMF last week, the market will have to weigh economic recovery against fiscal deficits for guidance.
A Closer Look at Financial and Consumer Conditions
The true health of the financial and credit markets is overlooked when immediate sentiment is on the rise. Looking beyond the temporary fluctuations in risk appetite, most signs of underlying stability are founded on government liquidity, guarantees and special programs. The most worrisome disconnect remains the break in credit availability between the major financial participants and retail/commercial lenders. While these key financial institutions are integral to smooth functioning market, a recovery cannot take hold unless funds make it to the productive participants of the economy. It an eventual return to growth to restart things; but aid will likely be removed by then.
For a trader, value is relative. This is especially true for underlying fundamental themes like economic growth. Last week, the G8 echoed the same sentiment as the Group of Seven and Twenty before it that there are early signs that an economic recovery is underway. Forecasts for the global activity and its major counterparts were mostly upgraded. And, in these revisions, there has been a clear advantage assigned to the outlook for the world’s largest economy. The FOMC [offered similarly upgrades](http://www.dailyfx.com/story/currency/eur_fundamentals/US_Dollar_Down_as_Optimism_1247694233011.html) to its own outlook. Its outlook for the 2009 contraction in GDP eased from 1.3 to 2.0% to 1 to 1.5%. In contrast, the outlook for unemployment was boosted sharply.
The Financial and Capital Markets
When investor sentiment is on the rise, prices in financial and physical assets are likely in tow. And, we certainly weren’t disappointed. In three days, there has been a dramatic correction in equities, risk-sensitive commodities, Treasuries, corporate fixed income and currency pairs with significant yield differentials. Considering the direction the markets have taken in the month prior to this week, it is safe to say that [this rally is still a correction in a larger trend](http://www.dailyfx.com/story/trading_reports/dynamic_carry_trade_basket/Risk_Appetite__Carry_Performance_Suffers_1247184946376.html) (though we can say the same thing of the June pullback in comparison to the March to June advance). This improved bias comes in two forms – passive and active. The passive aspect is the slow improvement in the economic outlook. The positive revisions from the IMF and FOMC are just additional support for a general drift in objective data towards the inevitable return to economic expansion. However, the speculative crowd discounted this shift long ago. The active driver is earnings data. Growing revenues promote both growth and financial stability. Eventually though, earnings will fade and the more elemental trends will be laid bare. But don’t think this is just relegated to sow improvements in growth forecasts, record deficits are starting to gather attention.
A Closer Look at Market Conditions
With 18[months of historical price action](http://www.dailyfx.com/story/special_report/special_reports/Chart_Patterns_and_Implications1247665941457.html), the fluctuations in capital markets over the past week barely show up on the charts; and they certainly do not alter any trends. However, a close look at the aggressive rally that has developed over just a matter of days inspires some confidence. The Dow Jones Industrial Average marked its biggest one-day advance in three months while crude has put in for its first, true bullish session in two weeks. However, it is best to take an objective approach to evaluating these statistics. The rebound has been aggressive; but it is burning hot and has little fire to support the heat. Aside from earnings, there is little fundamental fuel for continuation.
After a month of declines, the market is a little more sensitive to the possibility that there are risks just below the market’s passive surface. The more distant threats are that expectations for a return to growth are perhaps too optimistic; and the turn to expansion doesn’t necessarily mean it will be hearty, positive growth. However, this is a consideration for the next few months or quarters. For the coming days and weeks, the main concern is earnings. [Goldman Sachs reported record revenues](http://www.dailyfx.com/story/currency/eur_fundamentals/US_Dollar__Japanese_Yen_Fall_1247620649215.html) earlier this week; but are these numbers a product of accounting and government aid or genuine market health? Also, CIT is a reminder than is still risk as the lender flirts with bankruptcy.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>.