US Recession Deepening, How Long It Can Hold

Fundamental Outlook for US Dollar: Bullish

- US marks the biggest drop in payrolls since 1974
- NBER confirms the domestic economy has been in a recession since December 2007
- Record lows for manufacturing and service sector activity last month point to a deepening recession

It’s difficult to assign the US dollar a bullish fundamental bias considering the acceleration of the economy’s recession and the fact that American markets are the epicenter to a global financial crisis; but regular economics do not apply in times like these. In normal market conditions, expected returns hang in a delicate balance with a general tolerance for risk. When yield income – valued through assets in a specific country – drops relative to its international equals, that currency depreciates against its counterparts. This sums up capital flows, carry interest and fundamental speculation in interest rates. However, the setting for the markets is clearly far from normal – just look at the advance in the US dollar last week immediately following the report of a 533,000-person drop in national payrolls. Normal market theory has been thrown out the window as investors are no longer concerned about the potential for return. With volatility holding at levels many times greater than what it was just a year or two ago and global economies sliding into a grim recession, large investors and fund managers are merely looking for a place that their accounts won’t shrink. With time we have seen that that place is US Treasuries. Surely, the market must be desperate for a safe haven with three-month T-bills yielding little more than one basis point and two-year T-notes are paying out 0.9 percent per year. In fact, the entire yield curve is at record lows.

How long can a market go against such a basic law of market theory? That depends on speculators. As long risk sentiment holds as the dominant trend across all asset classes and all markets, caution will keep capital flowing towards safe havens. However, that is not to say that the US will always be the currency that panicked traders will turn to. Massive bailout efforts, rate cuts and stimulus packages have offered a sense of stability for the world’s largest economy; but this combined endeavor cannot prevent a recession or even a natural bear market. And, when financial conditions worsen and the economy continues its slide, policy makers will find they have few options left to curb the pain on a national level. Since US officials have been the most aggressive in their efforts, they could reach their limit first; and then the sanctity of US government debt will come into question. There are other countries that are less liquid but are experiencing better stability. As the global recession and financial crisis deepen, these alternatives will grow more and more appealing.

Characteristic of a primary fundamental theme, a shift in this market driver will not change over night - but will happen gradually. The calendar for the week ahead will help steer the bigger trend. Dollar traders have no doubt already priced in a recession; but how severe and lengthy of a contraction have they accounted for? A few growth-related indicators will test this. Pending home sales will gauge the ongoing housing market recession while the trade balance will reveal how effective a cheaper dollar is at drawing less international demand. The consumer will be the more important focus with retail sales for November accounting for the build up in spending trends into the holiday season while consumer sentiment will guide speculation for it going forward. Also thematic is inflation. Though factory and import-level price gauges are usually second tier readings, an expected plunge in annual readings would spell deflation which the Fed has little to no chance at fighting. This will be important considering the FOMC will decide rates on the following Tuesday.