As Risk Continues to Recede, the Dollar Rallies and Dow Tumbles

It may seem a contradiction in theory; but in practice, a general slump in risk appetite can occur while economic indicators are pointing towards a slow but steady recovery. This is the scenario that is currently playing out; and the dichotomous situation is a reflection of how markets can grow to be over- or under-valued. What we are seeing at this stage in the game, is the adjustment of one to the other.

It may seem a contradiction in theory; but in practice, a general slump in risk appetite can occur while economic indicators are pointing towards a slow but steady recovery. This is the scenario that is currently playing out; and the dichotomous situation is a reflection of how markets can grow to be over- or under-valued. What we are seeing at this stage in the game, is the adjustment of one to the other. Under different circumstances, speculative interests could have been held up by an influx of investment capital long enough for yields and growth forecasts to catch up to the market's prevailing level of 'fair value.' However, as it is, the recovery in economic activity and expected returns is running at too measured a pace to keep up with capital markets that have forged their most aggressive advance on record. And, considering the vast number of financial cracks that are opening up just beneath the market's seemingly smooth surface, there is ample reason for traders to worry.

And, worry they have these past few weeks. Last week, the Dow Jones Industrial Average and the US dollar made their opposing moves as the winds of risk aversion started to pick up. The former has definitively cleared a two-month, 300-point rising trend channel in a nearly 6 percent plunge that has ushered the benchmark to two-and-a-half month lows. As the speculative capital is drawn out of relatively risky positions, the capital that was borrowed to fund these outlays is being repatriated. With a benchmark market rate that has held at a discount to event its Japanese counterpart (a historical funding currency) since late August, the US dollar was a prominent source of funds for leverage and loans. As fading sentiment encourages this reversal in capital flows, we will see the greenback advance. However, long-term traders will ask: how long will the dollar be a funding currency?