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The fundamental pressure is building for the US dollar. Over the past few months, the currency has seen its response to shifts in market sentiment amplified as very early signs of forthcoming economic recovery have focused the criticism laid on policy officials' efforts to recharge the world's largest economy (and the subsequently the rest of the globe with it)
The Economy and the Credit Market
The fundamental pressure is building for the US dollar. Over the past few months, the currency has seen its response to shifts in market sentiment amplified as very early signs of forthcoming economic recovery have focused the criticism laid on policy officials' efforts to recharge the world's largest economy (and the subsequently the rest of the globe with it). Not only has this financial scrutiny raised concern that the economy could see its recovery dampened by excessive government exposure; but there have also been renewed threats that the US may lose its top sovereign credit rating and that other countries are discussing a replacement for the dollar in its role as the world's reserve currency. Neither of these issues is particularly novel or pressing right now; but they are nonetheless in the background and will be consistently revisited when more urgent fundamental issues are not at hand. In the fray, though, we should not forget the United States own struggle with recession. Friday's NFPs will signal whether the US recovery will pace or lag its counterparts.
A Closer Look at Financial and Consumer Conditions
Another week has passed with modest improvements for those traditional financial benchmark indicators. However, underlying and growing trouble remains. Both short-term Libor and Treasury rates are holding their respective lows; yet credit is still expensive and hard to come by for the consumer and speculator. This dichotomy reflects the ample liquid pumped into the market by the government and its providing stability primarily for the banking industry. It does not erase the toxic debt that is still floating in the market. What's more Fed Chairman Bernanke has started to sound the alarm, arguing a lack of a government exit plan could destabilize the markets.
Realistically, the US dollar has found its cues over the past few months mainly from its ties to market sentiment. However, even the safe haven aspect is tied to bigger growth concerns. The US economy could compete for capital flows if the ballooning deficits, government's influence in corporate America and lingering toxic debt load were balanced. Nonetheless, we could still see the dollar become the champion for return should it mark an economic recovery that outpaces its global counterparts. The signs of a decelerating recession and are perhaps more obvious in the US than many other countries. The true litmus test for a recovery will rest with NFPs.
The Financial and Capital Markets
As with the dollar, the broader financial markets are more attuned to sentiment than they are to cold hard fundamentals. However, considering the moderation in risk appetite over the past week, we may see market participants growing more leery of the long-term implications of data and policy actions being announced now. The big themes that were present through the worst of the crisis heading into the end of 2008 are still present. Economic recessions are deepening (even if the pace of contraction is ebbing); policy officials are still opening the liquidity valve; and bankruptcy is still a world splashing the financial headlines. With the recent failure of GM (and increasingly questionable nationalization of Citi), it is clear that conditions are not what they should be for a strong economic rebound that usually warrants the manner of rally that we have seen in speculative markets. When everything is said and done, long-term fundamentals and long-term market trends are still firmly set in their bearish convictions.
A Closer Look at Market Conditions
Capital markets maintain their trajectory; but the fundamental weight is building. The Dow hit highs not seen since January, while the S&P 500 reached November territory. Funds are clearly flowing into the market, supported by chatter of ‘green shoots.' However, it is important to ask: ‘would I buy shares or corporate bonds today and hold them for 6 months, one year, or more?' With major corporations slipping into bankruptcy and banks scattering to pay off their support loans well before the economy is soundly underway, there seems to still be risk in the medium term. Add to that, warnings that recoveries will be slow and anemic, and the potential for return isn't there.
Risk is defining market activity. It is the seeming lack of it that has led the traditional sentiment indicators to ease. The VIX is just off its nine-month lows, the Bloomberg-derived Junk bond spread has extended its steady depreciation to October lows and credit default premiums are near their lowest levels in nearly a year. These are certainly improvements from the near-panic levels that followed the most heightened pace of economic contraction and the worst of the credit crisis after the Lehman Brothers failure. An assessment of conditions now sees recession still deeply rooted and the banks or the broader market responsible for absorbing the toxic debt currently on Government ledgers eventually.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to John at (firstname.lastname@example.org)