Becoming Sophisticated About Risk

Dollar Rate Outlook Cut by QE3 Talk, Safety by Downgrade Warning


By John Kicklighter, Currency Strategist

14 July 2011 06:42 GMT
Credit Market Previous Current Change % Change Outlook *
DJ Credit Default Swaps 99.900 96.479 -3.421 -3.42% Improving
10 Year Junk-Bond Spread 473.78 506.02 32.24 6.80% Deteriorating
Credit Card Delinquencies 3.29 3.09 -0.2 -0.20% Improving
Mortgage Delinquencies 8.25 8.32 0.07 0.07% Deteriorating
US 3 Month Libor Rate 0.245 0.246 0.0005 0.20% Improving
Total Money Market Funds 2750.77 2707.55 -43.22 -1.57% Improving
Stock Market Last Week Current Change % Change Outlook
Dow Jones Industrial Average 11897.27 12168.48 271.21 2.28% Improving
Dow Jones Real Estate Index 225.83 234.39 8.56 3.79% Improving
Dow Jones Financial Index 355.86 363.53 7.67 2.16% Improving
Dow Jones Retail Index 93 96.54 3.54 3.81% Improving
S&P Volatility 21.32 18.14 -3.18 -3.18% Improving
Put-Call Ratio 1.5 1.57 0.07 0.07% Deteriorating
Market Breadth (Adv – Dec) 0.2755 0.3667 0.0911 9.11% Improving
Economic Indicators Previous Current Change % Change Outlook
GDP (Annualized) 2.8 1.8 1.8 1.80% Improving
Mortgage Applications 13 -5.9 -5.9 -5.90% Deteriorating
Initial Jobless Claims 438 414 -24 -5.48% Improving
Consumer Confidence 66 60.8 -5.2 -7.88% Deteriorating
ISM Manufacturing 60.4 53.5 -6.9 -11.42% Deteriorating
ISM Services 52.8 54.6 1.8 3.41% Improving
ISM Services – Employment 51.9 54 2.1 4.05% Improving
Credit Market Previous Current Change % Change Outlook *
DJ Credit Default Swaps 99.900 96.479 -3.421 -3.42% Improving
10 Year Junk-Bond Spread 473.78 506.02 32.24 6.80% Deteriorating
Credit Card Delinquencies 3.29 3.09 -0.2 -0.20% Improving
Mortgage Delinquencies 8.25 8.32 0.07 0.07% Deteriorating
US 3 Month Libor Rate 0.245 0.246 0.0005 0.20% Improving
Total Money Market Funds 2750.77 2707.55 -43.22 -1.57% Improving
Stock Market Last Week Current Change % Change Outlook
Dow Jones Industrial Average 11897.27 12168.48 271.21 2.28% Improving
Dow Jones Real Estate Index 225.83 234.39 8.56 3.79% Improving
Dow Jones Financial Index 355.86 363.53 7.67 2.16% Improving
Dow Jones Retail Index 93 96.54 3.54 3.81% Improving
S&P Volatility 21.32 18.14 -3.18 -3.18% Improving
Put-Call Ratio 1.5 1.57 0.07 0.07% Deteriorating
Market Breadth (Adv – Dec) 0.2755 0.3667 0.0911 9.11% Improving
Economic Indicators Previous Current Change % Change Outlook
GDP (Annualized) 2.8 1.8 1.8 1.80% Improving
Mortgage Applications 13 -5.9 -5.9 -5.90% Deteriorating
Initial Jobless Claims 438 414 -24 -5.48% Improving
Consumer Confidence 66 60.8 -5.2 -7.88% Deteriorating
ISM Manufacturing 60.4 53.5 -6.9 -11.42% Deteriorating
ISM Services 52.8 54.6 1.8 3.41% Improving
ISM Services – Employment 51.9 54 2.1 4.05% Improving

An Improving outlook means the Federal Reserve coulduse thisindicator

to support a rate hike. The opposite stands for a deteriorating outlook.

The Economy and the Dollar

The dollar has put in for a dramatic reversal this past week as the primary points of appeal for the currency have taken a clear blow. Up until Wednesday, the greenback managed a remarkable rally that guided the benchmark EURUSD pair to a decline that topped 740 points. However, the currency’s performance with this particular exchange rate was not replicated across its other liquid counterparts. What does this say about the dollar – that its strength was not uniquely derived from its own fundamental backdrop; rather this dramatic charge was leveraged by the weakness of its counterpart.

FED_WATCH_07_14_2011_body_Picture_1.png, Dollar Rate Outlook Cut by QE3 Talk, Safety by Downgrade Warning

Considering the Euro / US dollar exchange rate is the most liquid currency pair in the FX market by a wide margin; it should come as no surprise that evidence of a worsening sovereign debt crisis in the Euro Zone readily contributed to the greenback’s safe haven appeal. Yet, this primary role for the currency was significantly diminished by the commentary from Fed Chairman Ben Bernanke that further stimulus may be pursued and a warning from Moody’s that it was putting the United States’ top sovereign credit rating on review. Yet, while the market reacted to both developments with fervor; neither headline was off the markets radar. Not long ago, Standard & Poor’s warned the US could face a downgrade and the central banker offered possible scenarios for both tightening and loosening policy. That being the case, should we expect dollar to sustain its dive?

A Closer Look at Financial and Consumer Conditions

FED_WATCH_07_14_2011_body_Picture_7.png, Dollar Rate Outlook Cut by QE3 Talk, Safety by Downgrade Warning

The stability of the US and global financial markets is an immediate and real concern. In the past few weeks, we have seen demand (measured through cost) for liquidity rise to multi-month highs. This call for short-term funds finds much of its genesis in the European debt crisis. With market access problems spreading from Greece to Portugal, Ireland and even Spain and Italy; we are facing a clear deterioration in funding conditions for one of the biggest collective markets in the world. A far greater threat however is the possibility of a US downgrade. With the government facing an August 2nd deadline to lift the debt ceiling or face a technical default; the market is looking down the barrel of a proverbial gun. Nearly every asset in the world is priced on Treasury’s risk free rate.

FED_WATCH_07_14_2011_body_Picture_10.png, Dollar Rate Outlook Cut by QE3 Talk, Safety by Downgrade Warning

There is general consensus that the US and global economies are cooling after their strong post-recession recovery. However, that doesn’t mean that market sentiment is pricing in this reality. This past Friday, the market was delivered a clear shock when the Labor Department reported that June nonfarm payrolls rose a sparse 18,000 positions – a wide miss on expectations and the smallest increase in nine months. The details were even more sobering with participation at a quarter-century low, the average duration of unemployment at a record high and those that want a job but were forced out the market hitting a record as well. What is truly remarkable is that the stubbornly high level of unemployment contradicts the efficacy of the government and Fed’s stimulus efforts. This is the source of the anti-QE3 argument.

The Financial and Capital Markets

Volatility is more remarkable for the capital markets than direction. Over the past few weeks we have seen a dramatic rally for the benchmarks for investor-favored asset classes shift to sharp declines. The initial run up found little in the way of tangible fundamental support; but the efforts of European officials towards solving their financial situation and rumors of further stimulus from the US certainly offered a base for bullish speculation. The turning point for the US markets was the disappointing employment report.

FED_WATCH_07_14_2011_body_Picture_4.png, Dollar Rate Outlook Cut by QE3 Talk, Safety by Downgrade Warning

Though this is just one indicator for the world’s largest economy, it represents the largest single economic catalyst in the world and it happens to be one of the primary targets of the Federal Reserve’s policy decisions. As the EU sovereign contagion spreads further and headlines of fallout from a US downgrade overwhelm investors; sentiment will maintain a dovish bearing. However, there is another factor that could offer a short-term reversal – or just as readily exacerbate fears: the US 2Q earnings season. The action begins this week with JPMorgan, Citi and Google on the docket. The following week is far denser with its releases; but we should keep a broader view of the results. If overall earnings growth is slowing; it will undermine the increasingly fragile sense of risk appetite that has kept equities near highs.

A Closer Look at Market Conditions

FED_WATCH_07_14_2011_body_Picture_13.png, Dollar Rate Outlook Cut by QE3 Talk, Safety by Downgrade Warning

For the capital markets benchmarks, we see in price a lack of conviction but a sure sign of uncertainty. The S&P 500 and Dow Jones Industrial Average attempted a strong run to overtake three-year highs through the end of June and into the beginning of July; but the implications of setting new highs were greater than the market was willing to approve. Having pulled back sharply from this short-term cycle high; it is clear that speculative is increasingly prevalent without a commensurate participation from investors who are willing to stick with trends. One interesting factor is the gradual increase in volume that will support a prevailing trend.

FED_WATCH_07_14_2011_body_Picture_16.png, Dollar Rate Outlook Cut by QE3 Talk, Safety by Downgrade Warning

Where we have lacked for consistent trends, we have certainly made up for it in sheer volatility. The traditional readings using implied volatility figures through options have hardly budged. That said, price action has shown a remarkable increase in activity (measured through increased tick volume as well as wider daily ranges – not to mention dramatic turns in market bearings). Once again, we have to point out the short fall in the usual volatility readings – they are based on ‘insurance premiums’ that reflect the market’s fears. Expectations for maintaining and expanding stimulus, ongoing earnings growth and unrelenting economic growth has left the market with unrealistic projections and a book of excessive risk.

 

Written by: John Kicklighter, Currency Strategist for DailyFX.com

One response

  1. Ping-balik: Fed Chair Significantly Downplays Prospects for Additional Easing « Manajemen Resiko

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