Risk Appetite and Dour FOMC Projections Weigh on Dollar's Future

The dollar has benefited in the past through the fundamental beliefs that the world’s most liquid currency was a key safe haven and that the US would lead the global economic recovery. Neither theme has been working in the dollar’s favor this past week.

The Economy and The Credit Market

         The dollar has benefited in the past through the fundamental beliefs that the world’s most liquid currency was a key safe haven and that the US would lead the global economic recovery. Neither theme has been working in the dollar’s favor this past week. While the market’s primary focus is still shifting from risk to return; it is more and more apparent that after nearly six months sans a global crisis, investors are diversifying their capital away from governmentally-stifled American assets to those countries that can rally more readily. Though, perhaps the more prominent driver for the greenback (and the currency market as a whole) comes from the market’s renewed appetite for yield. Speculators are trying to forecast which economy is recovering the quickest while sustaining the least amount of damage in the interim. At one point, traders were assigning that title to the US; but [policy and growth forecasts](http://www.dailyfx.com/story/dailyfx_reports/daily_fundamentals/US_Dollar_Plummets_as_FOMC_1242856943418.html) have begun to undermine this conviction. Just today, the Fed minutes downgraded their forecasts for domestic output while Geithner warned that market conditions still required the government’s presence to maintain stability.

A Closer Look at Financial and Consumer Conditions

         This morning, Treasury Secretary Tim Geithner said in his testimony before the Senate that he saw tentative size of improvement in the American economy and markets. However, he went on to disclaim that “it is not quite time” to withdrawal government’s support just yet. Market operations seem to be improving and liquidity has been bolstered; but it is unclear how much of this is due to the Treasury and Fed’s presence in the credit markets. Geithner has suggested that he may start to unload distressed assets on the market as early as July. Will yield-hungry investors bid; or will such a move simply remind traders that there are trillions in illiquid assets still out there? 





         Growth is at the forefront of every market participant’s mind. As such, every piece of data or forecast from a notable economic player is a potential catalyst for sentiment and speculation. Today, the Federal Reserve (FOMC) released the minutes to their meeting from last month; and there was a clear, negative shift in the report’s projections and language. Played down was the suggestion that there were tentative signs of improvement for the economy through April; while the downgrades for growth projections were highlighted. The central bank now forecasts a [1.3 to 2 percent contraction in 2009](http://www.dailyfx.com/story/topheadline/US_Dollar_Tumbles_as_FOMC_1242843579580.html) (from 0.5 to 1.3 percent before) and two years of 9 percent-plus unemployment. 

The Financial and Capital Markets

         Indicators for risk and volatility continue to fall while capital markets maintain their bullish trajectory. However, the conviction behind these improvements has shown signs of flagging this past week. Fundamentals have not readily supported the broad recovery in risk appetite as the balance between risk and reward seems supported by sentiment alone. While the bear market of the past two years has been described by more than one commentator as a ‘crisis of confidence,’ the reality is that economics play as much a role in this prolific shift as traders’ emotions. Those banks that have failed the Fed’s stress test (as well as those that have passed it) have signaled their enthusiasm to repay the aid. This in itself is a gamble to the health of the broader market. Should sentiment continue to rise, such flexibility would be considered a boon. On the other hand, should firms spurn the Government’s assistance too early, the exposure could spark another failure or credit crunch. Eventually, the Government will attempt to sell the toxic assets it accumulated to the market and FASB rules will force banks to account for greater losses. It is just a matter of time.

A Closer Look at Market Conditions

         After months of congestion preceded by nearly a year-and-a-half of decline, investors are more than willing to respond to positive signs in the markets and economy. However, there is a difference between a retracement borne from momentum and a genuine trend change; and it is still not clear which scenario the markets are playing out just yet. Over the past two months, the benchmark Dow has advanced at a surprisingly, steady pace. Yet, this leader for the investment world is still more than 40 percent off its 2007 highs. Scrubbing much of the speculative interest behind the markets from the equation, commodity prices have been far slower to rebound without positive growth.




         Risk is always the perception of the crowd. Objective fundamentals may point to trouble ahead; and sentiment could effectively neutralize fear of volatility and loss ahead. This is a fragile state of being; and yet, it is one that the markets always subsist in. Looking to traditional measures of fear, we see the premium for uncertainty is still deflating. However, there are threats on the horizon. The Treasury is leaving the window for TARP open to smaller US banks as the Financial Times suspects another 500 could default. The bigger threat to liquidity though is the fact that the government will eventually have to push the toxic assets it has held back on the market. Will the market be ready?

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