What Fundamental Support does the Dollar have for a Sustained Rally?

After weeks of congestion, the dollar finally put some of the high volatility that has been plaguing the market to use with a quick rally today. This has certainly relieved some of the pressure on the battered currency by pulling it back from well tested lows against the euro, pound, franc and the comm bloc. However, we have to ask whether this was merely a relief rally or a genuine reversal in the greenback’s favor. To answer that question we have to consider the fundamentals that have developed in the past few days and weeks as well as the more influential themes that are still just outside of the speculative picture. This morning’s rally sharp advance can be partially attributed to the better-than-expected new home sales and durable goods orders reports; but neither has particularly altered expectations for the pace of the United State’s recovery or the timing for a return to a hawkish monetary policy stance. In fact, fundamentals for the US over the past week have actually deteriorated rather than improved. The CBO boosted deficit forecasts, the bank failure toll for the year hit a 17 year high and a federal court ruled the Fed will have to disclose details on its emergency lending programs. While indicators like the second reading of 2Q GDP and next week’s NFPs could feed speculation that the dollar is oversold, the currency’s long-term health is fading.  

The financial health of the world’s largest economy seems to be on solid ground. However, a look beyond the tentative rebound in risk appetite and thawing of credit to major banks, shows there are still serious problems that threaten the stability of an already fragile system. Most concerning through the short-term is ruling by a federal court judge Tuesday that the Federal Reserve has five days to release the details it has on those banks that accepted loans through the Fed’s 11 emergency lending programs. This could be a litmus test for how confident investors truly are in recovery behind markets and the economy. Other long-term concerns come from suggestions the money markets should be regulated and the handling of toxic debt.

Though it has lost some of its prominence among speculators over the past few weeks, the outlook for the United State’s recovery (relative to its peers) is still one of the primary measures for valuation and policy. Tomorrow, we will see the updated 2Q GDP data; and specific attention will be paid to consumer spending and capital investments –two keys for real growth after the recovery from recession. However, we should not lose site of the long-term forecast. Beyond the recovery, enduring growth and capital inflows could be severely curbed by the timing of policy taken now. Recently, officials suggested they would keep quantitative easing in place for some time and the CBO said deficits would build to $9 trillion over 10 years.

Despite the questionable health of fundamentals, capital markets have maintained their bullish trajectory. Equities have forged new highs for the year while investor funds are also finding their way back into the more controversial commercial debt and commodity markets. Whether we are in a certain bull wave will depend on the permanence of investor optimism and the success of officials’ efforts to increase regulations for the financial markets without handicapping them. Risk appetite is clearly flagging. A look at volume behind the stock market’s advance shows the volume backing the move has steadily diminished since the March reversal. Time is running out for fundamentals to take up the slack and usher the market to even greater highs. Regardless of time, however, developments are far from supportive of an unbroken advance. This past week, Guarantee Bank was the second largest lender to fail this year. The tally for failures is now up to 81 – the most since 1992. Add to this the office of Thrift Supervision’s quarterly report that showed the most troubled savings and lending institutions since 1995 through the second quarter as well as Presidential Economic Advisor Paul Volcker’s calls to regulate the liquid money market; and the availability of credit and potential returns in the market may be a bigger concern that simple growth.

After four solid days of rallying, the markets have spent this week drifting. This is a strange turn of events considering, the preceding rally drove the capital markets to new highs. The Dow Jones Industrial Average topped 9,500 and subsequently nine-month highs; yet completely ran out of momentum just beyond this milestone. Whereas speculative interests may be holding stocks up; the more necessity-based commodity market has actually retraced its some of its gains with bulls giving in to growth forecasts. Crude enjoyed a brief jaunt above 10-month highs at $93 before pulling back below this watermark. Without fuel for a rally, risk of a retracement grows.  

Popular measures of market risk seem to have found a level of equilibrium. Both the stock and currency market volatility indexes (the VIX and DailyFX Volatility Index) have spent another week stabilizing at their respective 11-month lows. However, as noted before, these are new levels of ‘normal’ that certainly factors in a risk well above the levels that we were used to before the financial crisis began or even through most of 2008. The same can be said of the upstream barometers. Default premiums and yields on risky assets is still significantly inflated from last year’s lows despite government guarantees and liquidity. Even at these levels, a financial shock could easily catalyze fears.