If there was any doubt to the dollar’s primary fundamental driver, the currency would forge a new 14 year low on a trade weighted basis and against its European counterpart while theDow officially climbed above the 10,000-mark. Investor sentiment is keeping the greenback held down while a current of optimism sweeps the markets higher. However, caution warrants a review of not only the dollar’s role as the financial whipping boy but also the endurance of the market’s exuberance. To maintain its status as the premiere funding currency, the outlook for the US recovery and interest rates must be weaker than its liquid counterparts. For the growth outlook, the world’s largest economy is on pace to emerge from recession at the same gait as most of its industrialized counterparts. Warnings from policy makers about measured expansion after growth readings turn positive is applicable to all. Realistically, the dollar’s downfall is yield. The Federal Reserve-set benchmark rate certainly has its influence; but investors are more concerned about real market rates. With the US 3-month Libor trading at a discount to even the Japanese equivalent, funds are both cheap and abundant – traits at which to borrow from but not invest in. We will need to see speculative competitiveness to revive the dollar.  

With the Dow trading above 10,000, corporate debt sales already hitting a record $1 trillion for the year and emerging markets drawing a steady stream of foreign capital; it would seem that financial conditions are as sound as they have ever been. However, there are certainly risks in the system. Fed Governor Tarullo specifically warned that banks face further “sizable” credit losses. This wouldn’t seem the case considering the robust earnings numbers for the second quarter and the initial signs for the third quarter; but this performance doesn’t seem to fully account for the building losses on loan defaults. Though conditions seem very strong right now, it will be a very different market when stimulus is withdrawn and the bull run levels off.

The US economy may be on track for expansion through the second half of the year; but the outlook for the next few years is still reserved. Coming just a week after the US unemployment rate ticked up to a 26-year high, the minutes from the FOMC’s last meeting and rate decision offered forecasts for the jobless rate to end 2010 at 9.25 percent and 8 percent through 2011. This is a good gauge for what we should expect for growth. Consumer spending accounts for approximately 70 to 80 percent of GDP; and therefore, high unemployment diminishes the means and desire to spend. Another highlight of the report was the debate over flexibility for the MBS purchase program; which could keep stimulus in place longer than investors want.

Everything in the capital markets seems to be giving traders the green light. The benchmarks for each of the major asset classes (the Dow for equities, crude and gold for commodities and the Australian dollar for FX) are all forging new highs and the third quarter earnings season is already off to a strong start. Yet, at what point can we say a rally is running on irrational exuberance? This is always easy to point out in hindsight. Accelerated reversals highlight markets that were clearly running beyond their fundamentals means. However, during all the excitement, it is very difficult to call. A long-term and objective view of the underlying facts though does provide a better grounding. The traditional capital markets are indeed at highs for the year and there are plenty of funds that have yet to make their way back into the speculative arena. Also for an outlook, growth is rebounding and expected levels of return are recovering alongside liquidity. On the other hand, the projections for expansion almost always come with a disclaimer that it will be temperate. What’s more, the strong earnings’ reports from financial firms seem to drive confidence beyond comparisons to the strength of previous years and questions as to the losses associated with building losses related to credit.

The Dow has finally surmounted the psychological, 10,000 barrier and crude oil has climbed above $75 per barrel; but were these technical levels the only thing holding back the seven-month bull trend? Certainly not. The attraction of such media friendly numbers often draws markets higher to relieve tension. Yet, at this point, we have seen a 55 percent rally in the US equities market and a 134 percent advance in crude in this relatively short period. Do fundamentals support such an aggressive trend? Can the recovery from the worst financial crisis in recent history (and record wealth destruction) justify these moves? There is no right answer; but it is interesting.

We seem to have finally come to the level that an increase in market activity behind risk-favorable moves can perk the traditional volatility gauges. That in itself is a sign that we are returning to a state of normalcy. The volatility index for the currency market has jumped to a four-week high after the dollar made for its drive to 14-month lows and high-yielders shot higher. It is the upstream measures of stability that we should be more focused on though. Junk bond spreads and credit default premiums are at their lowest levels since before the Lehman Brothers collapse; but they are still well above the levels seen before the financial system began to come apart in 2007.