An interest rate is one of the key elements to valuing a currency; however, there are times when other factors are more important to the market. Considering the dollar’s consistent strength in the face of the Fed’s lowering the benchmark rate to 1.00 percent, this is one of these times. However, exogenous influences like risk aversion/appetite cannot displace one of the market’s primary drivers for long. So, will rates help or hinder the dollar’s burgeoning strength when conditions return to ‘normal?’ That likely depends on the timing for a recovery in the global economy. For the FOMC’s part, another 50bps rate cut is largely priced into the market (with an 84 percent probability) and traders know full well that they have little scope to lower much further. Now it is a waiting game to see whether the BoE, ECB and others will bring their own rates to similar levels before the appetite for risk once again outweighs the burden of fear.  

Short-term funding costs continue their tumble to near-record lows thanks to the efforts made by the Federal Reserve and other central banks to flood the market with liquidity. However, the immediate availability of dollars does not equate to a rebound in investor confidence – though it does curb the most severe element of the financial crisis of the past months. The lasting effects of the credit crunch and crisis are beginning to show through. Lender and investor confidence is now focused on the economic recession and counterparty risk, which promises to weigh on investment for months to come.

The shock of the worst financial crisis since the Great Depression was merely an accelerant for the recession the global economy is heading into. And, while the US may be ahead of the curve in terms of the onset of the malaise and its policy response to help promote stability in the downturn, it is nonetheless heading into a significant slump. While the housing market collapse is already mature, we are just beginning to see the slow down in business activity and consumer spending. The jobless rate has climbed to a 14-year high and confidence will continue to plunge recent record lows.

Congestion has developed for the capital markets in a technical and fundamental sense. Taking a look to risk-sensitive assets like equity markets, we have seen ranges develop at the very bottom of bear trends that have brought the benchmark indexes to multi-year lows. From a sentiment standpoint, this reflects the transition in importance between two key market drivers. From July to the end of October, traders were more concerned about the scarcity of liquidity and the sheer momentum of asset depreciation, which led to step declines. However, now that the immediate threat of major bankruptcies and fund collapses has been mitigated; investors are reevaluating the outlook for the market and returns. The extent and severity of the budding recession clearly limits the outlook for production, consumption and revenues through the medium term. Do current lows already take into account the worst of the oncoming slump?

The benchmark Dow 30 is bouncing off multi-year lows, and a resolution to the recent chop will have to come soon – especially with the volatility underlying the market holding at extraordinarily high levels. Recently, a number of key quarterly earnings reports crossed the wires better than expected; but under most circumstances this is just a sharp drop in income offsetting forecasts for a devastating decline. As the economic slump is verified by data, the dour sentiment will catch up to projections for revenue and resource demand.

Risk aversion has not faded with the market’s take to range trading. This is more than obvious in the level of volatility that remains. For stocks (the most popular risk-appetite security), the VIX has steadily climbed to within arms reach of 80 percent. Fear is borne out of not only the outlook for economic malaise; but for the health of the key financial players as well. Credit default swaps have jumped back to record highs as banks continue to report major write downs. A good reflection of risk appetite is the record high level of risk premium in the junk bond spread.