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The previous week has been an alarming one for dollar bulls. With domestic data taking a back seat through the period, we have seen the benchmark currency's correlation to broader risk appetite trends revived just as risk appetite ignited following the strong Goldman Sachs numbers. With a series of major financial institutions and blue chips confirming a rebound in profit, speculators' forecasts for rising yields, capital investment and ultimately growth were bolstered.

The Economy and the Credit Market

The previous week has been an alarming one for dollar bulls. With domestic data taking a back seat through the period, we have seen the benchmark currency's correlation to broader risk appetite trends revived just as risk appetite ignited following the strong Goldman Sachs numbers. With a series of major financial institutions and blue chips confirming a rebound in profit, speculators' forecasts for rising yields, capital investment and ultimately growth were bolstered. This momentum lasted just long enough for the dollar to meet support that has kept the currency up for 10 months and resistance for equities that defines the highs for the year. Just as these significant milestones came into view, however, optimism was curbed. The quality of earnings data diminished significantly this week, leading participants to reevaluate their forecasts for business activity and growth through the second half of this year and beyond. In addition, the potential fallout from commercial lender CIT's troubles along with a shifting focus to upcoming GDP figures has drawn investors' sentiment elsewhere. This does not mean an immediate recovery for the greenback and tumble in risk appetite is inevitable; but it does complicate the fundamental situation.

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A Closer Look at Financial and Consumer Conditions

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The integrity of the financial markets was cast in shadow this past week after the Treasury rejected US lender CIT's request for a second round rescue. And, while the firm would later secure a private infusion of some $3 billion from debt holders later, uncertainty would continue to cloud the outlook for this credit market node as a forecasted $10 billion in debt maturing over the coming year along with a regulatory filing suggesting they did not have the liquidity to cover its August obligations put its survival into question. In the grader scheme of things, this single firm did not threaten the larger markets on its own; but its troubles suggested there were many more like it on the verge.

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It now seems the general consensus among market participants, economists and policy officials that the US economy has passed the worst of its economic recession and a turn to positive expansion could be seen by the end of this year or very beginning of 2010. Fed Chairman Ben Bernanke's testimony before Congress Tuesday and Wednesday confirmed as much. However, the central banker unexpectedly joined a growing call around the world for governments to start withdrawing its stimulus and work down deficits or risk stifling the recovery. This will be a contentious policy point moving forward; but in the meantime, the focus will turn to GDP numbers - the UK's this week and US next.

The Financial and Capital Markets

Risk appetite - and markets in turn - saw a hearty recovery over the past week. A sharp advance in equities, commodities, fixed income yields and carry trade interests confirmed the rise was founded in underlying factors like rising yields and a return of positive growth. The primary catalyst for such resounding bullishness was second quarter earnings. The rally began last week with the far-better-than-expected results of Goldman Sachs operations. As a TARP bank and blue chip in its own right, the firm's record profits were taken as a sign that all American financial institutions and industry leaders could print equally impressive figures and thereby validate hopes that the world's largest economy could recovery even before the most optimistic projections had accounted for. However, with each successive day, the accounting data deteriorated more and more. Now, with the greater share of large institutions having already reported, momentum has caved to technical and sentimental resistance. Without a new source of inspiration for growth and risk appetite, this recovery could collapse.

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A Closer Look at Market Conditions

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Regardless of what market you trade, it was impossible to miss the recovery in risk appetite over the past two weeks. For equities, the positive sentiment generated from earnings led to a six day rally for the Dow that has spanned nearly 800 points and subsequently brought the benchmark index to a six-month high. The same pace was echoed in commodities as the implications for growth and production trends stoked the outlook for demand. However, while both trends are still intact; the pace has clearly eroded. If stocks cannot capitalize on their new highs, a collapse in confidence could be more aggressive than the build up that brought the market to its highs.

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The S&P-derived VIX has pushed to a new 10-year low while currency market volatility has tumbled to equivalent lows. Adding credence to such signs that market risk is deflating, we have further seen junk bond spreads hold near their lowest levels since November and default premiums flirt with their lowest levels in a year. The reduction of fear is market-wide; but an enduring trend will likely depend on government support and the timing of its inevitable removal. As the recovery from recession takes hold, calls to reduce deficits grow. To remove aid without disrupting the market and economy's recovery will take precise timing. Too early, and the market will not be able to fend for its own.

Written by: John Kicklighter, Currency Strategist at DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.