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Dollar Rally Looks for Fuel - Can NFPs Carry the Bull Run?
Friday, 06 May 2011 06:42 GMT By John Kicklighter, Currency Strategist

It seems that the dollar has put in for a critical reversal just ahead of the market’s most market-moving economic
release. However, it is important to push back our speculative appetites to review the market with an objective eye
towards fundamentals and capital flows. The first thing we need to appreciate is that regardless of the follow
through on the greenback’s recent appreciation, it is still a tentative move.

Credit Market Previous Current Change % Change Outlook *

DJ Credit Default Swaps 89.498 89.753 0.254 0.28% Deteriorating

10 Year Junk-Bond Spread 453.76 444.85 -8.91 -1.96% Improving

Credit Card Delinquencies 3.76 3.53 -0.23 -0.23% Improving

Mortgage Delinquencies 9.13 8.22 -0.91 -0.91% Improving

US 3 Month Libor Rate 0.273 0.268 -0.0045 -1.65% Deteriorating

Total Money Market Funds 2731.79 2727.04 -4.75 -0.17% Improving

Stock Market Last Week Current Change % Change Outlook

Dow Jones Industrial Average 12763.31 12673.32 -89.99 -0.71% Deteriorating

Dow Jones Real Estate Index 242.27 239.11 -3.16 -1.30% Deteriorating

Dow Jones Financial Index 388.23 384.58 -3.65 -0.94% Deteriorating

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 Dow Jones Retail Index 99.47 98.11 -1.36 -1.37% Deteriorating

S&P Volatility 14.62 17.29 2.67 2.67% Deteriorating

Put-Call Ratio 1.21 2.08 0.87 0.87% Deteriorating

Market Breadth (Adv - Dec) 0.6580 0.5431 -0.1149 -11.49% Deteriorating

Economic Indicators Previous Current Change % Change Outlook

GDP (Annualized) 2.8 1.8 1.8 1.80% Improving

Mortgage Applications -5.6 4 4 4.00% Improving

Initial Jobless Claims 392 474 82 20.92% Deteriorating

Consumer Confidence 63.8 65.4 1.6 2.51% Improving

ISM Manufacturing 61.2 60.4 -0.8 -1.31% Deteriorating

ISM Services 57.3 52.8 -4.5 -7.85% Deteriorating

ISM Services - Employment 53.7 51.9 -1.8 -3.35% Deteriorating

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

It seems that the dollar has put in for a critical reversal just ahead of the market’s most market-
moving economic release. However, it is important to push back our speculative appetites to review the
market with an objective eye towards fundamentals and capital flows. The first thing we need to

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 appreciate is that regardless of the follow through on the greenback’s recent appreciation, it is still a
tentative move. One consideration that should curb bulls’ enthusiasm is that the currency could be
considered over-extended following a two-week plunge to near-three year lows having already spent
the past four months in a consistent decline. Profit taking is a natural occurrence even in a consistent
trend. Taking stock of the specific catalysts to this particular turn in the dollar; we should gauge the
influence of its chief drivers: relative growth; risk appetite trends and yield expectations. Economic
activity is well-integrated into the market’s forecasts; and there are few timely updates that can
dramatically change the outlook. Yield expectations can carry the dollar’s recovery the furthest; but
the FOMC statement this past weekend pushed back the reasonable possibility for gaining clarity on
changes to monetary policy until at least the QE2 expiration next month. Then there is risk appetite.
Capital markets have seen a significant leg down recently; but the S&P 500’s losses have so far been
modest. Any one of these drivers (and certainly all of them together) could bolster the dollar’s
position; but without the support, this tentative run would quickly stall. So, the question we should ask
is whether NFPs caters to these drivers in a meaningful way. It’s unlikely.
A Closer Look at Financial and Consumer Conditions

Assessing the health of the financial markets, we
should look beyond the steady trends of recent
months as well as the recent spike in volatility
that has shaken the US dollar back to
prominence. A fair appraisal of stability should
not just be based on price action but the
fundamentals behind the market as well. For a
while we have seen the value of assets rise
consistently while the reasonable outlook for
yield (return) has held steady or declined and the
risks associated to holding the position have risen
proportionately. Such an imbalance posses a
significant risk – though it can be ignored for
quite a long time as the masses growth
comfortable with the trend. This is what
economist John Maynard Keynes was referring to
when he said “markets can remain irrational
longer than you or I can remain solvent.
Having already been offered the FOMC’s take on
monetary policy going forward, the market is
once again taking the slow approach to gauging
the same drivers that guide the group’s efforts.
Following a dual mandate for stable price growth
and ‘full’ employment, we know more or less
what to look at. Knowing that the Fed continues
to write off headline inflation until it hits
oppressive levels; we are left to follow the labor
market. With the NFPs report, we have seen the
trend slowly turn from dramatic net job losses to
modest gains; but no single monthly increase
will immediately pull the unemployment rate
down from the 8.8 percent standing to the 5 to 6
percent range that the central bank is seen
targeting. That is why the market’s favorite
economic indicator hasn’t been able to drive
larger moves this past year.

The Financial and Capital Markets

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 We have seen a progressive shift in performance for the capital markets. Through the end of February,
there was a steady build in ‘risky’ positioning that was riding the wave of stimulus that the Fed had
pumped into the market back in November. Yet, momentum was already running thin when the
Japanese earthquake tested the stability and confidence behind this exposure. And, while this
particular event wouldn’t spark a lasting reversal; it was enough to cripple bulls permanently so that
they can’t simply carry an uncontested trend. Uncertainty in the middle east, US banks having to
reduce loan loss reserves to maintain strong earnings, consistently moderate-level economic releases
and expensive levels for assets are all starting to take their toll. When a true bear phase steps in, the
fuel will be provided by sentiment itself. Investors will see the balance of potential risk and return as
too precarious for them to simply maintain the buy-and-hold strategy that has worked so well since the
second quarter of 2009. In the meantime, a catalyst will be critical factor in securing this change. The
NFPs figure has limited scope in playing this role; but added to speculation surrounding the Euro area’s
financial trouble and emerging market capital collapse; it could help push us there.
A Closer Look at Market Conditions

We have seen a very convincing drop in the
broader capital markets; but the pace between
the different asset classes has been
different. Most aggressive are the declines seen
in commodities. The move began with silver
which had run a historic rally that doubled its
price in a matter of months. Recognizing
speculators’ hand in this drive, a consistent
series of margin hikes to trade the metal lead to
an abrupt drop. Noting the success of this move,
traders in gold and oil feared the same; and let
the dollar’s rally encourage a cover. Yet, the S&P
500 has shown far more restraint. Stimulus is
still prominent here; and increasing costs is
Volatility has jumped sharply in just the past
week. The dramatic activity in the underlying
very markets is the reason for this aggressive level of
activity; but we should sort out whether this was
a temporary reaction to just the intervention of
regulators to changing the functioning of the
market (raising margin requirements) or whether
this is a lasting drive as the market finally
discounts for existing risks. There are plenty of
fundamental uncertainties behind the market;
but it is the buildup in asset prices that provides
the real problem. Having pumped up the markets
so high and unbalancing the positioning to a
heavily long bearing leaves little reprieve should

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 more difficult. sentiment change. It is easy to have a sharp
decline; while a dramatic rally is unlikely.

Written by: John Kicklighter, Senior Currency Strategist

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