Reflecting the building fundamental and speculative pressure behind the US currency and assets, the dollar (on a trade-weighted basis) has fallen for nine consecutive sessions. This is the worst trend for the FX Market’s most liquid security in at least 10 years. Trying to forecast the path the battered currency takes from here on, we have to look at the same factors that drove it down to its current lull.
[B]The Economy and the Credit Market[/B]
Reflecting the building fundamental and speculative pressure behind the US currency and assets, the dollar (on a trade-weighted basis) has fallen for nine consecutive sessions. This is [the worst trend](http://www.dailyfx.com/story/bio2/Dollar_Remains_Pressured___Pound_1253111111429.html) for the FX Market’s most liquid security in at least 10 years. Trying to forecast the path the battered currency takes from here on, we have to look at the same factors that drove it down to its current lull. Assessing the situation from an absolute stand point, [data does suggest](http://www.dailyfx.com/story/bio1/US_Dollar__Japanese_Yen_Down_1253129324202.html) that the financial markets have thawed and the economy is returning to positive growth at a brisk pace. However, speculating on the direction of the dollar is a practice in comparative valuation. Traders are more concerned with how quickly the US economy is recovering compared to its industrialized peers. And, though growth potential is at the root of most fundamental concerns surrounding the currency market; traders are more specifically interested in [the outlook for return](http://www.dailyfx.com/story/special_report/special_reports/Dollar_Dangling_at_Critical_Support_1253139637678.html). As confidence in a recovery builds, the benchmark US three month Libor rate has fallen to a record low that puts the key yield at a discount to even its Japanese and Swiss counterparts. With risk appetite steadily rising and trillions of dollars of wealth still on the sidelines, the dollar future looks dim for the beleaguered currency.
[B][/B]
[B]A Closer Look at Financial and Consumer Conditions[/B]
Financial markets seem to be functioning at the same level as before the financial crisis struck. However, there are key disconnects that are preventing a return to normal that we have grown used to through the first of the decade. While liquidity has thawed to at the banking level and Libor rates have tumbled across the board, there is still limited access to credit for consumers and small businesses. In turn, the Federal Government is prompted to [maintain its extremely loose monetary policy](http://www.dailyfx.com/page/central_bank_interest_rate.html) in hopes that the assistance will eventually trickle down; but in the meantime, the dollar suffers for its low yields. Foreclosures are still high, earnings artificially inflated and leverage is once again excessive – stability is fragile.
If there is one thing going for the US, it is the economic outlook. Though the financial markets are distorted by the government’s incredible stimulus efforts, the economy is nonetheless benefiting with an impressive rebound that will soon turn the US back on to growth. However, how solid this trend in expansion will be in the near term is the question that more investors should be asking. Treasury Secretary Geithner said in his [testimony before the TARP panel](http://www.dailyfx.com/story/dailyfx_reports/daily_fundamentals/US_Dollar_Edges_a_New_1252627543848.html) that the recession is “very likely” passed; but he also said the subsequent period of growth will “feel” very week. Data confirms this. Adding to the anchor on spending seen in rising unemployment, the Census Bureau reported poverty was at its highest level in 12 years.
[B]The Financial and Capital Markets[/B]
As always, investors are ultimately concerned with only one thing: the tradeoff between risk and reward. In the past 12 months, the US and world governments have taxed their checkbooks and inflated their balance sheets in order to stabilize the flow of credit and prevent economic collapse. To prevent disaster on a global scale, officials have had to plug holes as quickly as possible; and inefficiencies were bound to develop. With the markets riding with a government rudder, investors have found their way back into their speculative endeavors. This is not in itself a bad thing; but when there is a rapid recovery in assets that are supported by far more modest fundamentals, the subsequent imbalance creates another bubble of sorts. There is a clear and constant feed for steady appreciation for traditional asset classes in the sheer volume of capital that remains in relatively risk-free (very low yielding) securities like treasuries and money market funds. In reality, these this supply is so vast that it could easily overwhelm any correction that develops through profit taking or a natural, bearish turn. Yet, the influx of this accumulated wealth has remained relatively restrained (perhaps due specifically to the reserved economic outlook); so a reversal can certainly turn off the tap.
[B][/B]
[B]A Closer Look at Market Conditions[/B]
Like general risk appetite itself, the capital markets have maintained their trend higher. Stocks have had a particularly impressive run over the past two weeks that has brought the benchmark Dow to its highest level in a year. The speculative aspect (not to mention the natural flow of capital into their traditional, easy to access market) has certainly benefited shares. In contrast, commodities have similarly bounced recently; but the upswing has been far more reserved. Economic performance is far more important to appreciation in natural resources; and stagnant growth into 2010 is a concern – but when will this thought filter into the financial assets?
For the stock market to be trading at its highest level in a year, risk has to be low. Indeed, the traditional barometers for fear maintain their mitigating trajectory. The traditional volatility indexes for stocks (the VIX) and currency market (the DailyFX Index) have pulled back to comparative lows. Further up the line, bank risk has similarly diminished. Credit default premiums are at their lowest levels in 18 months. For the high-finance crowd, junk bond spreads to lows not seen since before the financial crisis heated up in the final quarter of 2008. This leaves us to wonder: where do the rising foreclosures, consumer defaults, weak growth and bleak earnings forecasts fit in?
[I]Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>.
[/I]