The dollar has managed to hold general support that has developed at the very extreme of its range for the year. However, consolidation at such a meaningful threshold is more worrisome than it is soothing. Meandering at levels as significant as these increases the probability of a sharp breakout or retracement. What makes this situation even more volatile is the fact that the greenback isn’t the only asset flirting with significant levels.
The Economy and the Credit Market
The dollar has managed to hold general support that has developed at the very extreme of its range for the year. However, consolidation at such a meaningful threshold is [more worrisome than it is soothing](http://www.dailyfx.com/story/dailyfx_reports/daily_fundamentals/US_Dollar_Still_Waiting_for_1248478169773.html). Meandering at levels as significant as these increases the probability of a sharp breakout or retracement. What makes this situation even more volatile is the fact that the greenback isn’t the only asset flirting with significant levels. Carry interests, equities, commodities and fixed income are dabbling in new relative highs. Momentum has carried most of these securities to new heights (though the advance has been relatively restrained), placing further pressure on the safe-haven dollar to follow suit. Yet, without a clear and volatile shift in underlying sentiment or an elemental driver to confirm such a move; market participants may be able to spurn direction and contain volatility. But any quiet found will be short-lived. Stability established through the rest of the week is likely “the calm before the storm” as the first reading of US 2Q GDP approaches. Shifting from earnings to growth is a natural fundamental step which will be amplified through the release of other major economies’ growth reports as well as next Friday’s NFPs.
A Closer Look at Financial and Consumer Conditions
Credit flow through the financial markets continues to thaw; but there are still road bumps for policy officials and market participants to be wary of. This week, the 3mth Libor rate fell below 0.50 percent for the first time in history, suggesting liquidity to banks – propped up by government funds – is prevalent. More significant for long-term sustainability though is the ongoing contraction in the Libor-OIS spread, which measures the health of the money markets by gauging banks’ willingness to lend. However, it is worthwhile to account for the many loan provisions in 2Q earnings and the future need for the government to eventually unload its toxic debt portfolio.
The planets seem to be aligning for a US and global economic recovery. Lending credibility to policy officials’ endless reassurances, we have seen a steady improvement in sentiment, housing activity, corporate earnings and investment trends. However, there is a still a vital component missing for a true recovery to take hold – consumer spending. Americans may be more confident about the future, but rising unemployment, falling wages and lack of credit mean sentiment can’t naturally translate into spending. We will see how [this disparity is influencing the US recovery with Friday’s GDP release](http://www.dailyfx.com/story/currency/eur_fundamentals/US_Dollar_on_the_Brink_1248486816199.html). The consensus is for a sharp moderation of the recession to a 1.5 percent, annualized pace.
The Financial and Capital Markets
The financial markets have come through the second quarter earnings season with a bullish bearing. In fact, equities (the standard measure for investment sentiment) have managed to forge new highs for the year. The momentum in the accounting period, however, is slowing; and therefore, the drive behind risk appetite is similarly fading. There are still a number of blue chips that are scheduled to release in the days and weeks ahead; but the concentration of these industry giants is diminishing quickly. However, market participants will still be able to formulate their forecasts for a comparative US economic and financial market recovery; but they will be doing so through less speculative channels. In the coming two weeks, a number of [timely and lagging indicators are scheduled for release](http://forums.babypips.com/_workplace/events-calendar-workplace.htmlhttp:/www.dailyfx.com/calendar/). Top event risk and the easiest indicator to benchmark growth from will be the primary reading of 2Q GDP – though that is hardly the be-all, end-all. Monthly readings of labor, manufacturing, service sector activity, consumer credit, income and spending will offer a more granulated read on a big picture outlook.
A Closer Look at Market Conditions
Though momentum has been tempered, the capital markets have maintained their bullish trajectory through a general settling in risk appetite. The Dow has led stocks above the closely-watched 9,000 figure and are now testing highs not seen since November. Commodities on the other hand have extended their own impressive trends; but their respective highs are not as historical. This inconsistency seems minor; but it could have a significant impact on developing trends. With a ceiling still in place for many capital markets; it will be very difficult for speculators to carry their own rally. Alternatively, a strong GDP release could rekindle fundamental trends.
Risk continues to dissipate from the market. The more traditional gauges of volatility maintain their steady decline (the VIX is hovering just above a 10-month low). More convincingly, we have also seen upstream indicators extend their own slackening (default premiums have fallen to their lowest levels since June of 2008 and junk bond spreads have hit October lows). However, there are still sources of near-term and long-term risk that pose an active and lingering threat respectively. Near-term event risk in US GDP and NFPs can offer short-term rebound in fear. In contrast, corporate debt provisions, government withdrawal and many more issues could develop into large scale problems for the markets.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at <[email protected]>.