Looking out over different time frames, we can see different fundamental concerns weighing on the dollar’s health. Through the short-term, currency traders are almost completely concerned with risk appetite. The US dollar’s benchmark market rate (the three-month Libor) has leveled off; but it is still at a discount to its Japanese and Swiss counterparts.
The Economy and the Credit Market
Looking out over different time frames, we can see different fundamental concerns weighing on the dollar’s health. Through the short-term, currency traders are almost completely concerned with risk appetite. The US dollar’s benchmark market rate (the three-month Libor) has leveled off; but it is still at a discount to its Japanese and Swiss counterparts. With policy officials vowing to keep the overnight rate at its low levels until the middle of next year, rising carry interest is pegging the greenback as a funding currency. However, the Fed’s loose monetary policy will likely be reigned in soon; and when they do move it will likely be at a relatively quick pace. Through the medium term, the dollar’s troubles lie with the economy’s ability to recovery combined with the government’s ability to remove stimulus. This will be a delicate balance all on its own; but to support dollar strength, the country will have to perform this tight wire act more quickly than its global peers. Finally, we have the long-term implications for the US currency. The financial crisis has exposed [the flaw in having a single reserve currency](http://www.dailyfx.com/story/dailyfx_reports/daily_fundamentals/US_Dollar_Decline_Turns_into_1254873152651.html) and disconnected policy has amplified the world’s desire to revert to a more stable alternative. The dollar has dominated the FX landscape since the pound lost favor in the early 1900’s. Is there a viable alternative to the buck?
[B][/B]
A Closer Look at Financial and Consumer Conditions
The warnings of last week’s IMF Global Financial Stability report are still ringing in investors ears. The group suggests with its semiannual report that the world has only suffered half of the total losses that are expected to filter down from the worst seizure in global markets and the economy since WWII. This shouldn’t come as a surprise however as central bankers, policy officials, economists and most other points of authority have warned the market at large that there were still significant risks lying ahead and that the recovery will not immediately usher in the next, robust bull market. Government stimulus will be removed, unemployment will weigh and earnings will suffer. All of this will strain investment levels as it unfolds.
As assuredly as a cork held under water floats to the surface, the US economy is returning to positive growth. However, what does this mean? Projections for a recovery (the Fed’s Lockhart sees 2.5 to 3.0 percent growth for the third quarter) are just that – a reversal from the worst slump in generations. Beyond that preordained return to expansion, there is little supporting a sustainable pace of healthy growth. F[riday’s NFPs reported the 21st month of net job losses](http://www.dailyfx.com/story/dailyfx_reports/daily_fundamentals/US_Dollar_Down_as_NFPs_1254523732800.html) to send the unemployment rate to a 26-year high of 9.8 percent. [In testimony, Fed Chairman Bernanke said](http://www.dailyfx.com/story/dailyfx_reports/daily_fundamentals/US_Rallies_Ahead_of_NFPs_1254438661693.html) he does not expect growth to be strong enough to pull down the jobless numbers. This is a viscous cycle because consumer spending will keep growth depressed.
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The Financial and Capital Markets
The larger fundamental themes (growth, interest rates, fiscal deficits, etc.) seem to all be pushed to the background – but considering the pace of markets over the past three weeks, they could be leeching into the crowd’s psyche. There is still a strong headwind behind a steady advance of all speculative assets classes that promise some form of return that comes in the form of sidelined capital. Capital parked in traditional money market funds or Treasuries are collecting returns that when adjusted for inflation are actually negative. This offers [strong motivation for those investors that may still be cautious to take the plunge in into the speculative arena](http://www.dailyfx.com/story/trading_reports/dynamic_carry_trade_basket/Risk_Appetite_Pulls_Back_Once_1254431341885.html). However, we have not completely lost the need for liquidity in this strained recovery. The funds that have returned to the market since February are collective little interest or dividends; but capital gains do present an attractive paper profit. Should we see a wave of profit taking, we will likely find traders are not too attached to any long-term positions and what starts as a slow reversal can develop into a steep decline. Ultimately, sentiment is very fickle and both the senses of greed and fear are very sensitive through this period of stalled progress.
[B][/B]
A Closer Look at Market Conditions
While volatility has been exceptionally high this past week, there has not been a consistent bearing to come from this price action. The benchmark Dow has paced its global counterparts with sharp plunge to end last week and aggressive recovery to open the next. All of this comes through the ever unpredictable sense of risk appetite behind the market. Speculative interest are clearly at work; and even the basic decision to diversify away from safe haven assets is determined on the scales of potential return against inherent risk. Though still influenced by wants and hazards, the commodity market is the better growth gauge; and the congestion since June strikes a chord.
Impending risk would seem to be low considering the level of traditional gauges. However, perhaps we are making the wrong comparisons. Sure, the equity VIX index and [DailyFX volatility gauge](http://www.dailyfx.com/story/strategy_pieces/weekly_range/Forex_Strategy_Outlook__Range_Trading_1254765662612.html) are both well off their late-2008 highs; but they are still well above the averages that proceeded that period. The same can be said about the less popular measures of market peril. Credit default swap premiums and junk bond spreads have pulled back sharply from record highs over the months; but they are all still comparatively inflated. For those making a judgment on near-term risk, the leveling off and slow climb of junk bond spreads and the three-month Libor rate offer some concern.
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Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>.