Dollar Rally Stalls As Traders Question Safety In Deepening Recession

Are US Treasuries still the risk-free assets that they were 10 years ago? This is a question that can redefine the dollar’s trend for weeks or months. It seems the safe haven status that has supported the world’s most liquid currency for nearly eight months now is starting to meet resistance. Growth forecasts for the United States continue to diminish as policy efforts fall short of a consumer and credit-led plunge in economic activity. In contrast, the FX market’s typical high yielders are actually finding economic projections that point to a quick recovery - making these currencies attractive for both their sound fundamentals and comparatively high return. However, sentiment following growth projections and sentiment based on liquidity come under two very different states of fear and risk. The US has the deepest markets in the world; but without the pressure of an accelerating global recession and/or the build of another financial crisis, the American economy will be exposed to its struggling policy efforts and the economic trend towards a possible depression.

Financial conditions have deteriorated over the past week. Despite capital infusions promised by US policy makers, the banking system is coming under increased pressure by the potential downgrades and bankruptcy of sovereign economies as well as the potential that government officials will eventually turn to controlled collapses of major financial players. From a global perspective, the future of Eastern Europe is in focus as market participants wait to see whether they default on their debt obligations. With the US calling for a tripling of the IMF, leaders clearly expect worse. And, after Citi and AIG bailouts, market participants are just waiting for officials say to ‘no.’

Though the US is considered the most liquid market in the world and its government debt the benchmark risk-free asset; the economy’s prospects are grim. Riding on the negative revision to 4Q GDP just a few weeks ago, the dollar was dealt another blow last Friday when the February employment figure reported 651,000 Americans lost their job in February with a revision to 681,000 jobs lost in January – the most since 1948. With a jobless rate at a 25 year high (and expected to worsen), it will be far more difficult for policy makers to use stimulus funds to recharge consumer spending. As this economic slump matures, the ‘depression’ label will become more common.

The capital markets were able to stage a sharp – if not short-lived – rally through the early days of this week. While commodities and bond yields were enjoying a significant pick up of their own, the real volatility was behind the equities markets. The catalyst for an approximate six percent rally for the benchmark US equity indexes was a leaked memo from Citi which suggested the world’s largest bank would be profitable through the first half of 2009 after five consecutive quarterly losses. This is an about face as the US recently announced it was taking a large stake in the firm. As would be expected, this news was treated as a sign that financial conditions are starting to improve. However, the rally that followed this early news is more a relief from constant pessimism. Realistically, credit conditions are worsening and the worst of the recession has yet to be seen; so this move is likely just a bounce in a bear market.

The rally in equities this past Tuesday was the biggest in months; but it pays to put this young advance into perspective. Looking at the general shape of the market benchmark Dow since the beginning of the on-going financial crisis back in the summer of 2009; it is clear that the rally is hardly a sign that risk appetite has genuinely recovered and capital is once again flowing into speculative market. With economic data unfailingly supportive of a deeper recession and the world’s financial markets inching closer towards its next seizure, there is simply no balance in the rate of return to cover looming risk. One bright spot: commodity prices seem to be generating a bottom.

Risk indicators are returning to dangerous levels. While standard volatility indices are offering a slow recovery, this in itself is simply a sign of uncertainty for direction and market fundamentals. Looking further up the investment chain, it is clear that banks and funds are preparing for the worse. Junk bond spreads have tested record highs, credit default swaps are still on the rise (despite approval for ICE to clear the derivatives), and the TED spread for credit risk has rebounded to multi-month highs. Investors and lenders are growing increasingly concerned with the stability of many debt-laden economies and skeptical that the forthcoming G20 meeting will provide few results.