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Will the world diversify out of the US dollar and the liquid assets that it backs? Is it feasible? More importantly, is it advisable considering the still-fragile state of the global financial markets? These are the concerns market participants have developed for the American currency over the past week.

The Economy and the Credit Market

Will the world diversify out of the US dollar and the liquid assets that it backs? Is it feasible? More importantly, is it advisable considering the still-fragile state of the global financial markets? These are the concerns market participants have developed for the American currency over the past week. While it is not at all unusual to hear officials from developing nations comment on the need for a supranational currency to unbind themselves from the risk of the US dollar; there has been little action to suggest that this effort would begin anytime soon. Recently however, Russian central bankers have announced their intentions to reduce their holdings of treasuries to potentially fund their plans to purchase $10 billion in bonds from the IMF. This same plan has been echoed by Brazil and China. This effort may originate from a desire to reduce exposure; but with the global financial crisis and recession ongoing, it may be an effort that creates more problems. And, not to reduce the complexities of the dollar too much, fundamental traders must still account for the government's policy efforts and exit strategy, risk appetite, and very early signs of an economic recovery.

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A Closer Look at Financial and Consumer Conditions

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Another week has passed with circumstantial improvements for the financial and credit markets. Liquidity available to those banks and financial institutions deemed critical to the world's largest economy continues to swell; while access and costs for the consumer deteriorates. Today, the Federal Reserve consented to the Congress's demands for greater transparency to its emergency lending efforts by reporting some of the statistics in the loans made through May. However, beyond reporting on the $448 billion lent to 378 banks, no names were mentioned. These are sizable sums; and remind the market that this support will eventually be removed from circulation.

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The Federal Reserve released its current assessment of the US economy's health this morning in its June Beige Book (used by the Board of Governors in determining interest rates). Like Fed Chairman Bernanke's testimony to the House Budget Committee last week, the report made note of the preliminary signs of a decelerating recession while maintaining the economy's position in its historic slump. According to the statement, conditions remained weak or deteriorated - though five of the 12 districts reported moderation. This is the same sense of improvement as seen in Friday's 345,000 drop in NFPs. It was the smallest in eight months yet still brought the 17-month tally to 6 million.

The Financial and Capital Markets

Risk appetite is still at the helm for the capital markets - though the steady rally in confidence from early March through the end of May was still struggling to find direction this past week. A point of equilibrium may have been reached where sentiment has to be balanced out by fundamentals; but more likely, investors are waiting for the next catalyst for another leg of a progressive rally or a reversal that puts the market back on track with the longer term bear market. In measuring the constant flux between risk and reward, the questionable signs of ‘improvement' in economic activity through the monthly employment change were handily offset by news that preferred share conversion by Citi made the government the company's largest shareholder. What was initially intended to be a rescue for the sector is turning into permanent support that could ultimately hamper a natural recovery when the government removes the artificial liquidity it has provided.

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A Closer Look at Market Conditions

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The bullish bias behind equities and commodities these past few months is still in place; but momentum has stalled. The S&P 500 is developing its range between 925 and 950 for a second week. In comparison, crude oil prices finally pushed above $70/barrel to test highs not seen since October. Why the divergence? Aside from supply concerns, oil has retained its sensitivity to forecasts for an economic recovery. The strongest ISM manufacturing reading in eight months and a gain in factory orders supports the general premise that growth may slowly return. On the other hand, positive growth is still a long way's off and yields have yet to support the excesses of risk.

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Taking stock of risk, we have to better define the indicators which we follow when differentiating a short-term rebound from a long-term recovery. Volatility indexes for both equities and currencies are slowly deflating; while premiums for investment-grade assets and default risk have shrunk. However, these are arguable products of liquidity (temporarily supplied by the government) and some semblance of stability in over-the-counter markets. However, there is still trouble ahead. Aside from a blurry picture of where growth and respectable yields truly come in; investors will have to consider the government's eventual exit strategy from the market. Will credit hold; and what will be done with toxic debt?

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