Dollar Reserve Status Under Pressure, Bearing Brunt of Recovery

This past week was not a favorable one for risk appetite; but neither was it particularly encouraging for the US dollar. All eyes were trained on the G8 summit in Italy over the weekend; but the commentary wouldn’t sound like the unified policy body looking to bring a definitive end to an ongoing economic and financial struggle that market participants were looking for.

The Economy and the Credit Market

         This past week was not a favorable one for risk appetite; but neither was it particularly encouraging for the US dollar. All eyes were trained on the G8 summit in Italy over the weekend; but the commentary wouldn’t sound like the unified policy body looking to bring a definitive end to an ongoing economic and financial struggle that market participants were looking for. As expected, the Finance Ministers would point to signs of a tempered pace for the worldwide recession. However, the outlook was not positive enough to elicit a timetable and general strategy for rolling back government aid for the economy (and thereby deflate deficits). Treasury Secretary Geithner said it was too early to talk about an exit and that positive growth was still the top priority. This is the sensible approach considering positive growth is still a long way off and the markets are still unstable. In fact, just today 22 banks (7 that borrowed TARP funds) were downgraded by S&P. Further complicating the situation, international talk of diversifying away from the US dollar as a reserve is starting to find traction. Both China and Russia announced plans to sell Treasuries from their reserves; and members of the BRIC meeting discussed taking on each other’s debt.

A Closer Look at Financial and Consumer Conditions

         Though delayed plans to withdrawal government aid could stifle a recovery; keeping support in place may help to better establish economic and financial stability. Withdrawing liquidity, breaking loan guarantees and redistributing toxic debt back out into the market could quickly undermine the progress thus far. A clear sign that conditions are not yet back to their pre-2007 strength, Standard & Poor’s downgraded 22 US banks – a few that are even repaying their TARP. The long-term concern we should really be concerned with though is the government’s balance sheet of toxic debt. Opening up the private-public investment fund to pension funds smacks of renewed crisis.

                                    

         

         

         

         It is no secret that the world’s economy is suffering its worst economic slump in six decades; but through it all, the focus remains on the US. Considered the source of the current malaise, the globe’s largest economy is definitively showing an eased pace behind its economic recession; but the gleam of positive growth is still far off. From data, consumer confidence for the current month rose for the fourth consecutive month to a nine-month high and retail sales grew 0.5 percent. However, putting this into perspective, Fed Chairman Benanke and President Obama reiterated their projections for 10 percent unemployment while the IMF and World Bank kept their outlooks for contraction.

The Financial and Capital Markets

         Risk appetite was sidelined this past week by the cautious G8 rhetoric. Riding off of the steady advance in capital markets from March/April, investors were hoping for a definitive plan for the government’s timely exit from the free markets. Their plans to keep support in place not only bodes poorly for the outlook from officials’ side; but it further maintains the threat that the government can change the rules on equity and debt holders. Whether this is for the best or merely a stymie to a true recovery is a point of heated debate. However, a critical look at the fundamentals behind the market reveals it is still undoubtedly ailing. Officials are hesitant to project positive growth before the first half of 2010. Further stifling the hope for positive returns, the Fed is considering using its meeting minutes next week to assure the market rates will not be lifted until after the end of the year. The hope for return is not there. All it will take is the sudden return of risk to trigger another crisis.

A Closer Look at Market Conditions

         Equities investors were clearly unhappy about the outcome of the G8 meeting this past Friday and Saturday. The benchmark Dow finally cleared support at 8,600 for its first break and multi-session decline since February. For the securitized assets, the health of the credit market is perhaps the greater risk for the immediate future. This morning, nine separate banks announced they were repaying a combined $68 billion in TARP loans. Intended as a support through dangerous markets, their settling seems to be a hasty move more to appease the market’s opinion. For physical commodities, the disconnect for the rally is the lack of growth and forecasts for expansion.

                                   

         

         

         For months, the standard measures of risk have been deflating; and rightly so. The probability of another credit seizure or financial panic has quickly reduced with time, government support and a shift in general sentiment. Therefore, it stands to reason that those looking for insurance (how risk is truly priced) would not pay premiums that reflect a market on the verge of collapse. However, growth is still absent, corporate and sovereign downgrades are becoming more common, and there are still dangers for the world’s financial system (like eastern European debt). It seems we have finally found a point of equilibrium for this lingering risk with CDS rates and junk bonds spreads turning.

Written by: John Kicklighter, Currency Strategist for DailyFX.com
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