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Dollar Stabilizes, but Likely a Sale

The dollar and other currencies are largely firmer after Tuesday's sharp moves.

The U.S. dollar has come back bid Wednesday morning. It's nothing concrete to hang one's hat on, but gives the sense that Tuesday's moves were extreme.

Emerging market currencies are mostly firmer as well. Previously we had thought that today's session would be data driven and the asymmetrical risk of the data was to the dollar's downside, but given the outsized price action yesterday, and without compelling evidence that it is over, the focus is elsewhere.

Although the U.S. dollar has posted some corrective upticks in the wake of yesterday's slide against most of the major currencies, the pressure is not off of it. Today's news stream is likely to be negative.

Although it is often disregarded as "old" the revisions to fourth-quarter GDP could take on greater importance in the current environment. Growth appears to have been grossly over-estimated in the government's initial estimate of 3.5% growth. Owing to new data, including inventory, trade and construction reports, the consensus calls for a 2.3% reading. This will have knock-on effects, pushing productivity estimates lower and unit labor costs higher.

In the larger picture, the inventory cycle is perhaps the most important consideration and provided demand stays firm, the downward pressure from inventories will likely set the foundation for stronger growth. There is downside risk also emanating from the Chicago PMI. The consensus forecast is for a 50 reading after 48.8 in January. There is likely to be a bigger reaction if the Fed reading comes in below the 50 boom/bust level again than if it meets or exceeds the consensus forecast.

Existing homes sales delivered an upside surprise yesterday that elicited little market reaction. This group is something on the magnitude of 16 times larger than the new home market, but today's report of new home sales, which the consensus expects to be down 3.6% and offsetting a good part of the 4.8% increase in December, may also not do the greenback any favors. Given the heightened concern about cancellations, foreclosures, and various other underlying signs of fragility that have weighed on market sentiment, the market may be particularly sensitive to a negative-sign.

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It is difficult to know with any degree of confidence how much of the equity market declines abroad is just playing catch-up to the U.S.' slide and what is new rot. However, it does not appear that real investors -- mutual funds and asset managers -- have panicked after yesterday's unsettling moves. This speaks to the resilience of the circuit of capital.

Assuming that the stability of the US equity markets holds today (admittedly a big assumption), developments would once again reinforce the notion that while capital markets are prone to lurches from time to time, there is no reward for panicking. While maintaining disciplined risk management practices, long-term investors, as opposed to short-term speculators, can weather the lurches. This is not to say that such strategies will always work, but rather the point is that every time it does work, it would seem to reinforce the behavior in a competitive/evolutionary way. This is also not to say the one- to two-day move is completed. Downdrafts over the last few years have generally lasted longer than a couple of days and have been of deeper magnitude.

Another factor in the currency market today may be end of the month hedge and position adjusting. This could make the 11 a.m. EST/4 p.m. GMT fix particularly active. Given the decline in most European equity markets over the past month, some fund managers may have over-hedged their euro exposure and may need to buy euros. The Nikkei was one of the few major markets to finish the month higher (+1.27%), which may require some hedge-related yen sales.

Note that even with this two-day slide, most emerging Asian equity markets finished higher on the month, with Hong Kong (-2.26%), India (-8.2%) and the Philippines (-5.3%) the major exceptions. Global debt markets rallied and fixed income fund managers generally carry higher hedge ratios than equity investors, but often the hedges do not appear to be adjusted on a monthly basis. In any event, euro-zone 10-year benchmark yields fell 14-16 basis points over the month, while Japanese government bond yields declined by 9 basis points. Lastly, back-of-the-envelope calculations suggest that something close to $1 trillion of market capitalization has been destroyed by the global equity market slump, which was only partly offset by the bond market rally.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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