Can Confidence in the Dollar Improve Even as US Recession Deepens?

The US dollar is currently the safe haven of choice for global traders; but can it also be the market’s favored speculative currency when activity begins to perk up? That depends on how confidence responds to policy makers efforts to stabilize growth and the financial markets in the world’s largest economy. This past week, officials expanded their already extensive list of reforms and regulations by announcing a stress test of the 19 largest banks. The balance sheet reviews began today and the Fed said it would give the firms six months to raise private capital and would given them to choice to take funds from the market or the taxpayers to ensure they are solvent enough to weather an ongoing economic contraction. Along with the $787 billion stimulus plan, nearly a trillion dollars dedicated to expanding loans to consumers and small businesses, $275 billion dedicated to correcting the housing slump; and plans for a public/private fund to absorb toxic debt; it is clear that efforts are being ramped up. But is it enough to turn what has been termed a “severe recession?”

While there has been considerable tax payer money set aside for reviving credit to consumers and small businesses, we have not this capital put to work – and the mere mention of the aid is certainly not encouraging a skeptical crowd. On the other hand, the foundation of credit market health - lending at the banking level - is thawing. Global interest rate cuts, direct bailouts and liquidity infusions have lowered inter-bank rates are starting to offset the desire to boost reserves so that capital is once again changing hands. However, even with the full support of the US government there is a ways to go. In additional to the stress tests, there is still the CDS and other toxic debt to worry about.

Though the US government (and its global counterparts) is opening the coffers wide open and taking strides towards fundamentally altering regulations, the immediate outlook for growth is still dour. Last week, the Federal Reserve lowered the long-term for growth and employment forecasts that accompanied the minutes of its last rate decision. Most dramatic was the drop in 2009 GDP expectations from -0.2 to 1.1 percent down to -1.3 to -0.5 percent. As if to confirm this dreary projection, consumer confidence plunged to a record low yesterday with labor, business and income data tumbling. Friday’s GDP update will be the next significant milestone.

While the government attempts to put a floor under the economy, investor confidence remains elusive. In fact, just a few days ago, we have seen the benchmark S&P 500 equities index mark its lowest close since May of 1995. However, the clear break for the next major leg of the bear cycle has not yet happened. This broad indecision is to be expected as investors are still unsure whether the measures taken to stabilize the economy and markets will pay off – there seems little doubt that the immediate future will bring a deeper recession. Taking funds out of Treasuries and other risk-free assets to put then put them to work in the traditional speculative instruments would be highly speculative. And, considering the lack of potential return in a global market that is holding severely depressed interest rates, the risk/reward balance is not there. A spark of sentiment will eventually decide direction – but for better or worse?

Activity in the capital markets reflects the medium-term outlook for economic activity. With little hope for capital gains, dividends, production or consumption over the next few months; investors are see little reason to put their bank accounts in jeopardy by buying shares or commodities. However, speculation is a forecasting game; and eventually, traders will latch on to the cautious outlook for the economy to turn around in the latter part of this year and into 2010. For now, both the Dow and CRB Commodity Index are pushing new multi-year lows. With only modest technical levels left as support, a true extensive of major downtrends is a breath away.

Risk levels – though off record highs – are starting to climb once again. This rise in uncertainty and fear of loss flies in the face of constant upgrades to global governments’ efforts to revive confidence and normal market operations. Looking at the various measures of sentiment, we have actually seen volatility indexes (like the equity-based VIX and currency-based DailyFX Volatility Index) improve modestly. However, this could reflect improvements in the operation of derivative markets (and they are both still at historically high levels). In contrast, junk bond spreads and credit default premiums are climbing. As the global recession deepens, bankruptcy and downgrade potential rises.