Dollar May Benefit From Tempered Fears, Early Signs Of Recovery

Is there finally a light visible at the end of the ‘Great Recession’ tunnel? While the world’s largest nation is still contracting and the outlook for returns is still feeble, traders are turning back to their speculative roots to discount which economy will likely recovery first while accumulating the least damage through deficits and evaporated wealth. While the US isn’t in the best long-term position after the government’s aggressive round of bailouts and stimulus, the effort may very well lead to an early recovery. Over the coming week, there is plenty of evidence to weigh in on. Topping a long list of economic indicators, the April non-farm payroll report will act as a leading gauge for general activity. However, growth isn’t the only concern for the financial markets and the dollar. The lingering threat of another bank failure and/or credit seizure has stained confidence and curbed attempts to catalyze a genuine recovery. The Fed’s Stress Test results may present a turning point (for better or worse) for sentiment. This begs this question: is the dollar still defined by its safe haven role?

The capital markets are coming closer and closer to a state of financial stability. This past week, the benchmark 3 month LIBOR rate dropped below 1 percent for the first time on record. This historically low market lending rate is a manifestation of six months without another notable seizure in credit and the ongoing efforts by global policy officials to turn national rescue attempts into a global one. With the extended period of calm however, market participants have started to question when the artificial government struts can be removed to allow speculation and investment take over. Given the initial read on Stress Test shortfalls, it will likely be months.  

There is little doubt that the US (and indeed the world’s) economy is destined for an extended recession. However, it is clear at this point that all market participants have been tempered to the current malaise and are now looking for the ‘green shoots’ that precede a true recovery. So far, there have been very early signs; but predominately these improvements have come as a slower pace of contraction rather than a turn to positive growth. This week, the gradual shift in sentiment could be accelerated through a round of high-impact indicators. Friday’s payrolls will carries the greatest weight; and the better than expected ADP figure has certainly raised the bar.

While traders have taken in their collective breath ahead of the Stress Test results due Thursday, risk appetite has maintained its steady appreciation over the past few weeks. In fact, April’s advance was the best monthly performance for US equities in 17 years. Other speculatively-tipped asset classes have produced similar results. However, the fundamental justification for such an aggressive advance remains an issue. Calm markets have encouraged capital held on the sidelines to be reinvested (a large portion following the usual buy-and-hold lines). However, putting these funds back to work is difficult to do when there is little return to be made above and beyond risk free. This alpha will come when earnings, dividends, government dampers and credit are once again prevalent. Fading fears surrounding financial crisis help this development along; but positive growth is the true catalyst of returns. Encouraging readings from employment, consumer spending and industrial production figures could bring us one step closer.

Capital markets have maintained their trajectory, but momentum has been spotty. With a revived advance this week, the benchmark Dow Index pressed nearly four month highs and is over 30 percent off its multi-year lows from back in March. However, it is important to put this recovery into the perspective of the bigger picture. This same index is still 40 percent off the record highs bulls were forging before the crisis struck in the summer of 2007. Considering it will take a long time before credit is as prevalent as it was two years ago and investors to build up the same level of investable capital; a renewed bull market would like be subdued at best.

Traditional volatility indicators have tumbled to new lows this past week (the VIX is at a seven month low and the DailyFX FX Volatility Index is hovering near similar depths). However, this may be more a sign that systemic risk is easing rather than a complete drop in danger. An immediate concern for investors is the results of the Fed’s Stress Test. Initial reports suggest that 10 of the 19 major US banks under the microscope have insufficient capital to weather an ongoing recession. However, there has been an obvious effort to leak the disappoint results ahead of time and the ability to raise capital in the market has been on repeat. Then again, this isn’t the end all for earnings.