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While there is little momentum behind underlying risk appetite; the bearing on sentiment is enough to weigh on the market’s top funding currencies. Maintaining this market role for well over a year now, the US dollar is struggling to regain its footing as speculative interests retain their hold over the broader markets. Looking forward, the currency’s next prominent trend will no doubt follow the tack that investor sentiment defines

The Economy and the Credit Market

While there is little momentum behind underlying risk appetite; the bearing on sentiment is enough to weigh on the market’s top funding currencies. Maintaining this market role for well over a year now, the US dollar is struggling to regain its footing as speculative interests retain their hold over the broader markets. Looking forward, the currency’s next prominent trend will no doubt follow the tack that investor sentiment defines. And, in this distinct correlation, the greenback is sidelined by the same dynamic that has anchored progress in equities, commodities and fixed income. Rousing a clear bearing and true conviction on sentiment (whether it be bullish or bearish) has proven a complicated task. The reflection period afforded by the year-end holiday has clearly awoken market participants to the reality that government support will eventually be rolled back and rates of return are still anemic. On the other hand, the ranks are hesitant to unwind their risky positions without a clear reason to do so. In these conditions the dollar will remain stuck. Yet, this does not mean the currency will lack volatility. In the background, the dollar can still move up and down the risk spectrum. To effectively shed its status as a funding currency, the greenback will have to find support from interest rate expectations. However, the outlook for rates over the next 12 months is a paltry 75 basis points and just today, the Fed’s Dudley suggested the “extended period” the group has upheld is likely longer than six months.

A Closer Look at Financial and Consumer Conditions
Financial conditions are improving rapidly: at least that is what recent data and indicators are suggesting. Financial market stability is coming under increased duress – and it is just a US-based problem. Small imbalances are turning into incredible fissures, and all it takes is investor sentiment to crack for the markets to fall apart. At the positive end of the spectrum, China has had to take steps to curb rampant speculation and deflate potential bubbles before they burst. On the other end of the spectrum, Moody’s has warned that the Greek and Portuguese economies are looking at a “slow death” if they are unable to rein in budget deficits. In the middle, the US is groping for stability through regulation and increased investor participation. However, the government is already rolling back emergency stimulus. Can the market stand on its own?	The US and global economy are improving – but at a measured pace. To this point, the world’s largest economy has merely put in for a recovery from its worst depression in generations. This is not the precursor to a roaring period of growth; but rather a move towards stability that precedes a tepid phase of growth as employment, consumer spending and business investment recover. However, considering the level of most speculative markets, it seems investors may be overestimating the economy’s potential. Something has to give, and it will almost certainly be sentiment. Taking an objective reading on economic health, the December NFPs finally tipped a positive payroll figure; but full employment is still a very long ways off.

The Financial and Capital Markets

Investors sentiment is living on borrowed time. Traders have pushed traditional capital markets to highs not seen in over a year as sidelined funds find their way back into the speculative arena. However, the tides have slowed as the bulk of those market participants willing and able to fuel the rally and reap the rewards of capital appreciation have already put their funds to work. In the meantime, regular income (dividends, coupons, and other sources of yield) has advanced little – leaving investors in safe assets. Will this cautious group be encouraged to buy into the rally that equities and commodities have enjoyed and subsequently revive the dominant trend. Or, will the risky markets’ high levels further discourage conservative investors from taking the plunge until a correction puts prices closer in line with fundamental values? The latter scenario is the more probable as sentiment is more reactive and less enduring dynamic. This leaves us with the million dollar question: when will risk appetite normalize?

A Closer Look at Market Conditions
Traders are trying to wring every basis point of return out of the markets as they can. Investors’ favored assets have pushing to new highs; but the conviction and fundamental support that was once driving the advance is now absent. There is no better reflection of risk appetite than the benchmark Dow Jones Industrial Average. This index has maintained its bullish trajectory; but the pace of growth is sluggish with volatility bound by a tight three-hundred point range. Commodities have shown greater levels of activity; but large swings have prevented a clear trend from developing. Should fear take over, expect a clear bearing to once again develop for the market.	Risk premiums are pushing to excessively low levels. Traditional volatility indicators (based on implied volatility calculated through options), default premiums, investment grade rate spreads and other measures of risk are all pushing to new lows. This is a natural reaction to increased investor participation (deeper liquidity); but does it mean conditions are inherently safer? Far from it. There are distinct threats to market stability (a downgrade for Greece, another round of write downs from financial institutions, the withdrawal of government stimulus, etc); but in the end, a collapse in risk appetite itself will likely end the run. An effort to book profits can easily undermine fragile sentiment.