After a temporary bounce, the dollar was put back on pace to push new lows for the year. As long as the battered currency is directly linked to risk appetite through its record low market rates, the selling pressure will persist. However, with time, either the correlation between the currency and yield demand will fade or the all-consuming trends in sentiment will give way to diversification (or both).
[B]The Economy and the Credit Market[/B]
After a temporary bounce, the dollar was put back on pace to push new lows for the year. As long as the battered currency is [directly linked to risk appetite](http://www.dailyfx.com/story/currency/eur_fundamentals/US_Dollar_Overdue_for_a_1253314255861.html) through its record low market rates, the selling pressure will persist. However, with time, either the correlation between the currency and yield demand will fade or the all-consuming trends in sentiment will give way to diversification (or both). Over the past few weeks and months, it has been the single-minded surges in risk appetite and plunges of risk aversion that have been tempered. Through the recovery following the worst financial crisis on recent record, capital markets have risen in concert as sidelined capital was reinvested into traditional asset classes. There is still a substantial glut of wealth that is squirreled away in ‘risk-free’ assets; and in the near-term, the redistribution of this capital will mean selling US Treasuries and money market funds (and therefore the dollar). However, with time, the intense desire for yield will balance out with the low levels of expected returns; and US based assets will be seen as more competitive. In the meantime, the dollar can improve its own circumstances by shedding its status as the currency market’s primary funding currency. Comments from the Fed’s rate decision today signify the [first steps towards withdrawing monetary stimulus](http://www.dailyfx.com/story/topheadline/US_Dollar_Spikes_Lower__US_1253730078236.html) and contemplating rate hikes.
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[B]A Closer Look at Financial and Consumer Conditions[/B]
Financial stability is something that is touted far and wide by policy makers and politicians; but the case for such an optimistic point of view is still flimsy. It is true that capital markets are starting to recovery and are less volatile, risk of a major default has declined and credit is more accessible; but all of these characteristics of recovery are founded on [I]temporary[/I] intervention. [Government guarantees, favorable tax policy and transplanted toxic debt will eventually be reversed](http://www.dailyfx.com/story/trading_reports/dynamic_carry_trade_basket/What_will_be_the_Next_1253239288622.html). The true litmus test for market health will be whether investor appetite can support financial stability on its own. After a record evaporation of wealth and considering the limited returns expected in a slow recovery, expectations should be reserved.
Economic activity in the world’s largest economy has “picked up” [in the words of the Federal Open Market Committee (FOMC)](http://www.federalreserve.gov/newsevents/press/monetary/20090923a.htm) today. This is a notable two-word phrase from the central bank when caution has been the general pace that has been taken for so many months. Nonetheless, just as we have seen the ‘recovery’ in so many lines of economic data, we can still see in the statement’s commentary a slower pace of deterioration rather than unabashed expectations of expansion. Policy officials suggested, “household spending seems to be stabilizing” but offset such sentiment with job losses, fading incomes and tight credit. Ultimately, this press release is one step closer to confirming real growth just ahead.
[B]The Financial and Capital Markets[/B]
The plunge from the dollar in the past few days has invariably meant there has been a pickup and risk appetite; and subsequently, the capital markets have rallied. However, we can see that the appreciation is still flagging. We are no longer seeing the same uninterrupted rallies from equities and commodities that were so common in the second quarter. As long as there is a surplus of unutilized capital (left in safe haven assets like Treasuries and money market funds), investors will respond to the steady recovery in the economy and financial conditions by reallocating into speculative assets. However, even though there is a natural draw for capital to return to the traditional yield-producing securities; the burden of risk and reward still holds. The mass of wealth that has been kept out of the speculative arena until now has done so because investors are still uncertain about the future and especially critical of the recent rally. Taking the potential for returns into account, aside from capital appreciation (which would depend on a steady inflow of money), the outlook for yields in dividend or interest is severely limited as economic growth is expected to be tepid and financial regulation regulates investors’ options.
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[B]A Closer Look at Market Conditions[/B]
Capital markets are still supported by the steady return of sidelined traders. Yet, this trend grows increasingly stretched with each week that passes without a notable correction. Eventually, the capital from those investors simply reinvesting for a quick return or to get in ahead of the curve will dry up. There is still a considerable accumulation of wealth that does not have the luxury of being nimble through liquidity. For these managers to find their way back to the market, the market as a whole has to appreciate and underlying growth has to support it. In the meantime, we watch the steady advance in stocks work against a depreciation in volume and stall in commodities.
As would be expected with a tentative rebound in risk appetite facilitated by government guarantees, we continue to see a steady decline in perceived risk. Traditional volatility gauges like the VIX for equities and DailyFX Index for currencies are sliding to new lows for the year. Further up the line, we can also see the premium charged for risky assets is at pre-Lehman implosion levels and credit default rates are near their lowest levels since the beginning of January. However, how does the picture change when we strip out the support of temporary monetary policy? It is impossible to tell; but this is a question that officials will be asking themselves in the months ahead as exit strategies start to kick in.
[I]Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>. [/I]