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Forex: Dollar - Where Is the Redemption Rally with the S&P 500 Slump?
John Kicklighter

Talking Points:

  • Dollar: Where Is the Redemption Rally with the S&P 500 Slump?

  • Euro Finds Little More than Stability with IMF Growth Upgrade

  • Japanese Yen Weigh their Risk Link Through Carry as Equities Dive

Dollar: Where Is the Redemption Rally with the S&P 500 Slump?

Is this the risk aversion move dollar traders have been waiting for? The S&P 500 suffered a 1.2 percent tumble Tuesday – the biggest in drop in six weeks and a clear break of 2013’s robust support. Furthermore, the VIX Volatility Index (considered a ‘fear’ gauge) climbed above 20 percent for only the second time this year. While the benchmark US equity index is a particularly effective measure of speculative appetite as the tradition portfolio’s ‘risk ‘ asset and its further backstop in stimulus support, it does not alone establish the investment habits of the entire market. And, given the headwinds to the greenback in its local debt ceiling risk; the dollar needs the kind of risk aversion that leverages liquidity.

To override the innate trouble of foreign capital turning away from a US fiscal crisis, the dollar needs to see global financial conditions freeze up and thereby leverage fear while also limiting viable alternatives for liquidity. While the S&P 500 and Dow Jones Industrial Average’s trendline breaks are notable first steps, we have not seen the panic and market-wide deleveraging that are the dollar’s true strengths. We see that clearly enough in the Dow Jones FXCM Dollar Index’s (ticker = USDollar) hold to an ever-tightening trading range – less than 40 points. Perhaps a better illustration of the fundamentals behind this lack of contagion in fear though is the level of the FX Volatility Index. Where the equities version has soared to stones-throw of the 2013 high, the currency measure of fear is at a five month low and continues to drop from its June high. If the dollar is to rally – not simply jump higher – sentiment needs to devolve to more dire and desperate levels.

As we keep a close eye on the intensity of investor sentiment, the ingredients for the changing tides must be monitored. Day 8 of the US government shutdown passed with both the White House and House of Representatives digging in on their budget standoff. To that effect, the market is starting to take the risk of at least some short-term US funding issues seriously (any delay in payment is a technical default). Credit default swaps have swelled to levels last seen in August 2011 when a Washington standoff led the United States to a downgrade of its AAA credit rating by Standard & Poor’s. Another sign of trouble, yields on one-month Treasuries have soared to their highest level since 2008 – leading to an inverted yield curve short of the two-year mark. Meanwhile, giving capital market bulls some hope, it was rumored that Fed Vice Chairman Janet Yellen would receive President Obama’s official nomination to replace Ben Bernanke tomorrow. She has been the frontrunner for some time, and the Fed’s Taper timetable is already delayed. It’s hard to imagine Yellen will seriously expand the dovish pace.

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