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Over the past week, the dollar has maintained its high-level volatility; but the pace of the market still has not translated into direction. This is partially a consequence of thin liquidity through the end of the summer and into the long, holiday weekend; but the same general affliction for the broader speculative market suggests the unusual calm has deeper fundamental roots.

The Economy and the Credit Market

Over the past week, the dollar has maintained its high-level volatility; but the pace of the market still has not translated into direction. This is partially a consequence of thin liquidity through the end of the summer and into the long, holiday weekend; but the same general affliction for the broader speculative market suggests the unusual calm has deeper fundamental roots. Investor sentiment (and thereby capital markets) has steadily appreciated over the past six months through an evolution of early adoption, an influx of sidelined capital and on prospects for an economic recovery. Yet, just as pessimism overshot reality through the end of the financial crisis; so too can optimism exceed reasonable expectations for returns when the masses are eager to reenter the market and recover wealth lost over the past two years. Sentiment makes for an overwhelming theme and it will very likely decide the ultimate break in the dollar and its subsequent trend. However, these fundamental winds will steadily lose their influence with the markets and the greenback in particular. Ultimately, the degradation of this fundamental link may very well be hastened by the economic prospects for the currency itself. Growth and interest rate forecasts could shift the dollar's position on the risk spectrum. Though, with speculation of early rate cuts constantly checked and actual expansion elusive, it seems the US will maintain its anti-risk qualities.

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A Closer Look at Financial and Consumer Conditions

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Financial markets may have avoided a severe shock to the system this past week - at least temporarily. The court ruling that required the Federal Reserve to release the details of its emergency lending efforts by this week was put on hold pending an appeal by the central bank. This was to be expected; but it is important to release that this data will inevitability find its way into the public's hand eventually. Timing will be critical. Should this information be released too early, those firms that are still holding sizable loans could easily be deemed unstable - encouraging a run on an otherwise secure bank by account holders and investors. In trying to avoid such an outcome, banks paying down their TARP loans may actual weaken the system.

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Consumer spending in the US seems to be ‘leveling off.' At least that was the assessment from the minutes of the FOMC meeting last month. This would be an encouraging assessment (as this major component of the economy accounts for approximately 70 percent of growth); but the warnings that accompany this review are more consistent and threatening that any optimism that comes from a group whose job it is to stabilize market sentiment. Along with the aforementioned comments, the central bank said the downside risks ahead were many; and unemployment would decline slowly while bank losses threatened corporate health. Friday's NFPs will offer a more objective estimate of when actual growth should be expected.


The Financial and Capital Markets

Financial markets pitched lower this past week even though there were few tangible drivers for such an aggressive move. The real impetus for the decline was sentiment. Such a consistent advance from speculative assets when the economy is still technically contracting and has little hope of generating positive yields in the near future begs the question: where is the drive from optimism coming from? There is certainly a significant source of strength to be found in potential reallocation flows. There is still a glut of capital still in treasuries, money market funds and other relatively ‘risk-free' instruments that can find its way speculative arena and subsequently inflate prices. However, there is a reason this capital is still in the wings. To this point, the recovery in equities and other asset classes can be labeled a recovery from the most pervasive financial crisis since the Great Depression. However, just like economic activity, a recovery is not the same thing as true expansion. The potential for growth, capital investment, earnings and rising yields is the fuel for a true bull market. With consumer spending stunting true growth, interest rates likely under wraps until the middle of next year and the Fed warning credit losses at banks; a six month rally seems like it may be surviving on borrowed time.

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A Closer Look at Market Conditions

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Capital markets have experienced a sharp reversal over the past week. The benchmark Dow stock index has tumbled nearly 4 percent from its 10 month highs set just last week. Turning away from volatility (which has been warped by the thin liquidity) the trend of four consecutive daily losses that pulled the market lower was the worst trend since the series of declines through the end of February. It may be that the restoration of liquidity will in turn revive sentiment; but long-term trends in volume would suggest any rally will not extend far without a meaningful correction. Conviction behind the six-month advance has steadily eroded since it began.

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Short-term risk is exceptionally high; but it is the outlook beyond the next few weeks that is the real concern. Over the coming week, the US market will be unusually thin due to the Labor Day weekend. This has already led to a sharp correction in stocks and high volatility in currency markets. However, a major shift in underlying risk appetite will not be decided when the markets ranks are unusually shallow. Therefore, a true break from recent congestion (notable particularly with the dollar-denominated majors) will be founded when the market is running on a full tank. NFPs, the G20 meeting, rising defaults and failing banks are just a few catalysts that could ultimately revive fear.

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