With liquidity topped off after last week’s extended US holiday, market participants are once again trying to establish the primary, fundamental driver for the dollar going forward. Through the immediate future, interest rates will continue to influence the greenback, but its impact has certainly changed in the span of a year.

The Economy And The Credit Market

With liquidity topped off after last week’s extended US holiday, market participants are once again trying to establish the primary, fundamental driver for the dollar going forward. Through the immediate future, interest rates will continue to influence the greenback; but its impact has certainly changed in the span of a year. From 5.25 percent back in July of 2007, the Federal Open Market Committee (FOMC) has responded to a financial crisis and global recession by lowering the benchmark all the way down to 1.00 percent. However, the Fed isn’t the only central bank that has had to use monetary policy to help revive investor confidence and growth. Policy authorities around the world are quickly bringing their benchmarks towards zero. With the market pricing in a 50 percent probability for another 75bps cut on December 16th, the Fed may soon be the lowest yielder. However, if this is seen helping US growth before its international counterparts, a cut may actually help the dollar as carry interest vanishes.

A Closer Look At Financial And Consumer Conditions

Panic has dissipated, but the fundamental problems underlying the health of the financial markets are perhaps worse today than they were back in October. Investor confidence is still severely depressed. Lending (investment from a different perspective) is being held back by rising default risk, few signs of stimulus efforts actually helping the economy, banks hording bailout capital and a deepening recession. Both Treasury Secretary Paulson and Fed Chairman Bernanke have begun adjusting their efforts to target the consumer; but signs of a severe recession will certainly defer a recovery for months.

There were few economic indicators released over this past (shortened) week; but what was offered was enough to weigh growth forecasts even lower. The ISM manufacturing report hit a fresh 16-year low while the broader service sector plunged record lows for a good reading on activity through November. Elsewhere, providing an official stamp to what most had already feared, the NBER confirmed the US economy is in a recession and has been for a year now. The next key report for gauging the health of the economy will be this Friday’s NFPs, which is expected to print the biggest monthly drop since 1981.

The Financial And Capital Markets

Congestion remains the dominant theme for not only equities but risk appetite in general. Since the wave of deleveraging in October that triggered a broad panic, various markets have attempted to hold their respective lows; but at the same time, there has been little effort to turn the well developed bear trend. Such a shift in sentiment is not likely anytime soon. Investor confidence is weak and growing weaker. The outlook for a global recession – and the lack of clarity for when activity may actually take a turn for the positive – has severely reduced expectations for revenues, yields and production going forward. As businesses struggle to cope with a lack of credit and demand, output will fade and bring employment down with it. In turn, the global recession will intensify, pulling commodity prices down even further and exacerbate global imbalances that have been artificially sustained through policy and regulations.

A Closer Look At Market Conditions

The short-term rebound in equities seen last month has been quickly unwound. A dominant bear trend is entrenched, and for good reason. Bailout packages have been instituted to establish liquidity for financial firms; but the crisis has already made the jump from Wall Street to Main Street. The three major, US auto manufacturers are asking for $20 billion in aid while home builders are gathering their own numbers. Financial difficulties combined with a recession would be enough to produce a natural bear market; but a weak holiday season could revive the overwhelming bear trend in the months ahead.

There will never be a complete absence of risk appetite in the capital markets; but we haven’t seen as broad a flight from risk like this in decades. At this point, risk isn’t the only factor holding the market back. A few quarters ago, a flare up in the credit crunch or speculation of a major bankruptcy could tip the scales and put the bears in control. Now, this balance has been permanently skewed as a sharp drop in global yields has left little room to venture into a market that has a permanent haze of risk. In the US specifically, Treasury yields across the curve have tumbled to record lows and the VIX is holding above 60 percent.

John Kicklighter a Currency Strategist at FXCM.