US Dollar: Is Risk Aversion Behing the Latest Move?

Softer economic data weighed on the US dollar today but the shallowness of the decline is a testament to the market?s overall demand for risk as well as its tolerance for US dollars. The combination of another weaker housing market report, lower consumer confidence and warnings that the problems in the sub-prime sector could spill over to prime should have set off alarms for all carry traders and dollar bulls. However, instead of dropping, the US dollar actually recovered over half of its losses against the Japanese Yen after the housing market numbers.

In addition, the dollar held steady against the Euro and British while gold prices hit a 3 month low. If the market was truly becoming more risk averse because of the housing market issues, then gold prices would rise and not fall because investors tend to flock to the safety of gold whenever they are risk averse. Profit taking ahead of the Federal Reserve meeting has been blamed for the divergent market behavior as bond yields continued to rise. This suggests that the market still expects the Federal Reserve to remain hawkish despite the problems in housing. The main reason the Federal Reserve will choose to do so is inflation. The national average of gasoline prices are back below $3 a gallon but the cost of milk, butter and corn are all up sharply. This has forced companies like Domino?s Pizza, Starbucks and Wendy?s to either report a shortfall in profits or plans to increase prices. These changes will eventually hit core prices, which is one of the Federal Reserve?s primary inflation gauges. Therefore as long as we do not see a company like Washington Mutual take a big write-down in prime loans over the next 2 days, further dollar weakness ahead of the Fed rate decision should be limited. More important than the problems in housing, which have been with us for some time is the outlook for consumer spending. Consumer confidence sank to a 10 month low in the month of June. Weaker confidence is not likely to bode well for spending in the months to come.