Risk Appetite Drives Volatility But Where Will the Dollar Find Direction?

Another week of extraordinary volatility has kept the dollar busy; yet from all of this activity, the market has yet to take a direction. The broader markets seem to be influenced by unusual market conditions complicated by a transition in fundamental concerns. The disconnect between volatility and direction can be partially attributed to low levels of liquidity (frequently associated to the summertime season for the Northern hemisphere when many market participants are on holiday). However, should fundamental convictions line up correctly, liquidity for this characteristically deep market will matter little. There are two prominent drivers that can return the dollar to a certain bearing: risk trends and relative growth forecasts. In the past few months risk appetite has maintained its volatility; but the currency’s correlation to this ever-present theme has weakened with time. In contrast, the focus on the United States’ pace of recovery has increased. Has the extension of the TALF program and policy officials’ liberal policy approach ensured an expedient recovery from recession and (more importantly) established the foundation for a timely return to a true period of growth? Time will tell, but market participants will speculate in the meantime.

There are clear signs that liquidity among the majors banks is returning to a new ‘state of normalcy’ (it will be some time before we return to pre-2007/2008 financial crisis levels). However, outside the sphere of the major financial players, credit is still strained; and this is where unforeseen problems will incubate and explode. Small banks are just starting to find access to government aid; but it is still not wide spread. A Bloomberg study reported more than 150 lenders have non-performing loans that account for more than 5 percent their net capital. This could easily trigger the next credit crisis. Aside from this particular threat, we have commercial real estate, lingering toxic debt and a severe lack of consumer credit.

Over the past week, the outlook for global growth has soured alongside market sentiment. However, the prospects for the US specifically have eroded on its own. For tangible economic data, consumer confidence has been knocked off its pace of steady recovery as the grim outlook for employment and wages sets in. This will be a factor that we will have to monitor closely going forward. While the US (and other developing and developed countries) may be pulling itself out of its recession, true expansion may be out of reach for some time if consumers, lending and exports don’t support the recovery. Next week, we will have the second reading of 2Q GDP numbers. Look closely at the component data to garner a true sense of trend.

The steady advance in financial markets and investor sentiment since the first quarter has stalled yet again over the past week. Without big ticket economic indicators or events (like FOMC or NFPs) to feed speculation that the economy is on a steady path to growth, market participants have been left to evaluate their positions and match it up to true fundamentals. The assessment is not promising. So far this year, the markets have risen on the notion that speculative assets were undervalued after the credit and financial crisis through the end of last year. Naturally, the return of normal market functioning after events like the Lehman Brothers collapse would slowly encourage sidelined capital back into the market and lift expectations for competitive returns. However, there has been a severe drop in investable wealth that will not be built up in this recession; and money managers will long be left with the taste of the crisis. In the end, the real engine for the markets is growth and yield potential. Here, skepticism is creeping back into the outlook. Equities have rallied nearly 50 percent from their lows; yet the future promises little more than a stagnate growth beyond its recovery.

Equities, commodities and other capital markets have been weighed down by the fickle influences of sentiment. A break in the steady flow of positive economic data has exposed investors to a period of reflection. How strong is confidence that market conditions are improving and the outlook for returns is steadily improving? A look at market volume may offer a different story than the appreciation in asset prices alone. Highlighting volume levels in the equity market as the Dow Jones Industrial Average has risen to new highs for the year, it is clear that there interest is in fact contracting as the index appreciates. Investors may sense the rebound is exaggerated.

The risk factors behind the markets are both numerous and tangible. However, this wouldn’t be the consensus if we followed the trend in the commonly followed indicators alone. The VIX and DailyFX Volatility indexes have both maintained their decline, default premiums are still in a long-term bear trend (though they recently jumped) and the yield advantage on relatively risky assets has lessened with growing interest. Yet, this is a symptom of comparing our current condition to the wrong period. In contrast to conditions through the worst of the crisis, conditions are certainly much better. However, when measured against levels predating this unusual event, risk is still high.