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Last week, dollar traders and the broader market were surprised to see the Fed officially announce its intentions to buy Treasuries and double its purchases of mortgaged backed securities. This week, concern over the health of the US currency is far greater.

The Economy And The Credit Market

Last week, dollar traders and the broader market were surprised to see the Fed officially announce its intentions to buy Treasuries and double its purchases of mortgaged backed securities. This week, concern over the health of the US currency is far greater. Not only is the US economy ailing and its fiscal deficits ballooning; but now there are concerns that the world may eventually vote to replace the dollar as the world's reserve currency with a basket or what China has called a ‘super-sovereign reserve currency.' As the world's largest holder of US Treasuries, their concerns are taken seriously; but this is an issue that has been made even more pressing by the fact that Russia and UN among others have voiced similar opinions. US President Obama, Treasury Secretary Geithner and the Fed's Bernanke have all brushed off concerns over the dollar's health and suitability; but this is no doubt going to be a topic brought up at next week's G-20 meeting. Considering the group's history of inaction however, the likelihood that such a drastic shift will be adopted is low.

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A Closer Look At Financial And Consumer Conditions

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Investor sentiment has improved rather rapidly over the past week; but the overall health of the financial markets is still in the doldrums. As the risk of protectionism rises and calls from economic leaders to other economic leaders to do more grow louder, the global nature of the financial and economic crisis has manifested itself. Recently, the US has taken its major counterparts to task for not increasing their efforts to brace their own economies; to which many respondents have suggested America is digging itself into a hole. Regardless of which side is correct, it is starting to look more and more like the US, China and UK are expected to take the lead for reviving the world.

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As debate over the dollar's role as a safe haven and reserve currency, the limits to US bailout efforts and the feasibility of sentiment in the financial markets rage on; the world's largest economy is still dealing with what is likely its worst recession since the Great Depression and probably one of the worst contractions in the industrialized world. Over the past week, second tier data has started to hint at stabilization. Both factory orders and housing sales have shown significant improvements; but this comes within the worst trends on recent record. Until employment, consumer spending, mortgage approvals and construction improve, the trend is still down.

The Financial And Capital Markets

Capital markets have extended their biggest rally in months (and for some asset classes it has been the biggest rebound in years). Such an incredible rally has obvious led many market participants to question whether this is the sign of a genuine recovery that so many have been waiting for. However, when searching out a true source for investor confidence, there are few leads that promise to snuff out risk and revive expected returns. A frank assessment of the global economy leads us to a severe recession that is likely to grow worse before it improves. Hope for returns through increased fixed investment, rise in production (by way of demand), and an influx of capital into the markets is fleeting at this point. The most poignant factor for the health of the capital markets is investor confidence. Even if growth recovers and business revenues pick up; the bear market to this point has wiped out significant levels of capital and changed market dynamics permanently.

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A Closer Look At Market Conditions

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It is a common saying that there are rallies in a bear market. This is the adage to keep in the back of our minds as both the equity and commodity markets extend their aggressive rebounds. The surge in stocks has been particularly bold; so it stands to reason to be especially cautious. The S&P 500 is working on its best monthly performance since 1991 despite expectations for the US recession to deepen and obvious problems with global policy makers establishing a coordinated plan to turning the recession and financial crisis around. A rebound in commodities is more encouraging as its speculative interest is lower; but it still does not confirm a true recovery.

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Though it is still uneven, risk trends are showing additional signs of improvement. Over the past week, there was a sharp drop in credit default swaps that can be attributed to the Fed's announcement that it was doubling is purchases of mortgage-derived securities, additional details on the US plan for a joint public/private fund to purchase toxic assets by Treasury Secretary Geithner and the progress for a clearing house to be established for the otherwise frozen CDS market. However, these are all plans that could take some time to actually implement and take effect. In the meantime, recessions are worsening, global bickering is ongoing and credit-related institutions are failing.

Written by: John Kicklighter, Currency Strategist
Questions? Comments? Send them to John at jkicklighter@dailyfx.com.