The November US retail sales report has really set the cat amongst the pigeons. For so long we have become accustomed to judging the move in the USD US Dollar) based on daily gyrations in risk aversion. Well, that may all be about to change. There was an inkling that all did not look right following the release of the November jobs report which unsurprisingly helped to boost risk appetite but surprisingly boosted the USD too.

It was easy to dismiss the USD reaction to year end position adjustment, markets getting caught short USDs etc. What’s more, the shift in interest rate expectations following the jobs report in which markets began to price in an earlier rate hike in the US was quickly reversed in the wake of Fed Chairman Bernanke’s speech highlighting risks to the economy and reiterating the Fed’s “extended period” stance.

There is no shortage of cash rich investors in Asia, even amidst the current troubles in Dubai. Indeed, sentiment in the gemstones market is particularly upbeat, with a rare five-carat pink diamond selling for a record HK$84.24 million in Hong Kong. Perhaps this is a good reflection of abundant liquidity and of course wealth in Asia, and in particular China, with talk that mainland Chinese investors were strong participants in the diamond auction.

It's not just diamonds that are selling for record prices; gold hit a fresh high above $1,200 and, once again, at least part of this is attributable to the appetite of Asian central banks as well as demand from China, as the country tries to increase its gold reserves. The rise in gold prices has coincided with a bullish announcement from the world’s top gold producer that it has completely eliminated its market hedges earlier than forecast due to the positive outlook on prices and waning supply.

Dubai’s bolt out of the blue is hitting markets globally, with the aftershock made worse by the thin liquidity conditions in the wake of the US Thanksgiving holiday and Eid holidays in the Middle East. Estimates of exposure to Dubai companies vary considerably, with European banks estimated to have around $40 billion in exposure though what part of this is at risk is another question.

The lack of information surrounding the Dubai announcement made matters worse. The aftermath is likely to continue to be felt over the short term, with further selling of risk assets likely. Indeed, there is still a lot of uncertainty surrounding international exposure to Dubai or what risk there is to this exposure and until there is further clarity stocks look likely to face another drubbing.

Risk appetite is failing to show much improvement this week and sharply weaker than forecast US housing data dampened sentiment further following other soft data over recent days including the Empire manufacturing survey, industrial production and retail sales less autos. The data will add to concerns about the pace and magnitude of growth in the months ahead.

A sub-par recovery and benign inflation outlook are the two main reasons why the Fed will not hike rates for a long while yet. This was echoed by St. Louis Fed President Bullard - a voting member of the FOMC - who gave a little more colour on the Fed’s “extended period” statement. He highlighted the probability that US interest rates will not be raised until the first half of 2012.

Speculation has intensified that China will allow the CNY to resume appreciation. As well as a move in USD/CNY NDFs, implied options volatility has also risen. Speculation of CNY revaluation follows a significant change by China’s central bank, the PBOC to its stated FX policy in its quarterly monetary policy report last week.

The timing of the change in rhetoric should come as little surprise as it coincides with greater international calls for a stronger CNY to help rebalance the global economy as well as an improvement in economic data domestically. China has so far resisted such calls but the time may now be right for China to play its part in the global rebalancing process.

The USD index is trading close to a 15-month low and direction remains firmly downwards as risk appetite continues to improve and the USD’s status as a funding currency remains unaltered. Whether it’s a weak USD driving stocks higher or vice-versa, US stocks are currently trading at 13-month highs, maintaining the negative correlation with the USD index.

One currency that has failed to take advantage of the weak USD over recent days is EUR/USD and its failure to make a sustainable break above 1.50 highlights that momentum in the currency is fading. EUR/USD looks vulnerable on the downside in the short term, with resistance seen around 1.5050. Speculation that China will resume CNY appreciation has taken some of the steam out of the EUR given that it implies less recycling of intervention flows into the currency.

Markets are increasingly discounting stronger than expected Q3 earnings. Further gains in equities and risk appetite may be harder to achieve even if profits continue to be beat expectations, which so far around 80% of Q3 earnings have managed to do. Measures of risk such as the VIX “fear gauge” have highlighted an increasingly risk averse environment into this week. The negative market tone could continue in the short term.

The USD has found some tentative relief, helped by the drop in equities and profit taking on risk trades. The fact that the market had become increasingly short USDs as reflected in the latest CFTC Commitment of Traders’ (IMM) report in which aggregate short USD positions increased in the latest week (short USD positions numbered roughly twice the number of long positions), has given plenty of scope for some short covering this week.

Although there appears to be some consolidation at present the USD remains on a steady downward path and is likely to continue to face a combination of both cyclical and structural negative forces.

Cyclical pressure will come from the extremely easy monetary policy stance of the Fed as well as the ongoing improvement in risk appetite. The structural pressure on the USD continues to come from the diversification of new FX reserve flows (mainly from Asian central banks) as well as concerns about the reserve value of the USD in the wake of massive US fiscal and monetary stimulus.

Markets have had an exhilarating run up over recent weeks. Since the start of the month the S&P 500 has risen by close to 7%, gaining around 58% from its March low, as the evidence of global economic turnaround has strengthened and the outlook for earnings improved.

Nonetheless, the rally in equities has meant that valuations are starting to look stretched again. For instance the price/earnings ratio on the S&P 500 has risen to its highest level since January 2004 (according to Bloomberg data), perhaps hinting at the need for a degree of investor caution in the days and weeks ahead.

Interest rates have some way to go before they take over from risk aversion as the key driver of currency markets, but as noted in my previous post, low US interest rates have played negatively for the dollar. As markets have continued to pare back US tightening expectations and US interest rate futures have rallied, interest rate differentials have moved against the dollar.

The most sensitive currency pair in this respect has been USD/JPY which has been the most highly correlated G10 currency pair with relative interest rate differentials over the past month. It has had a high 0.93 correlation with US/Japan interest rate differentials and a narrowing in the rate differential (mainly due to a rally in US rate futures) has resulted in USD/JPY moving lower and the yen becoming one of the best performing currencies over recent weeks.

The dollar was beaten up over the past week, finally breaking through some key levels against many major currencies; the dollar index touched 76.457, the lowest since September 25, 2008. The usual explanation for dollar weakness over recent months has been an improvement in risk appetite. However, this explanation fails to adequately explain the drop in the currency over recent days.

Although we have seen a multi month trend of improving risk appetite it is not clear that there was any further improvement last week. On the one hand the ongoing rise in equity markets points to a continued improvement in risk appetite; the S&P 500 recorded its biggest weekly gain since July. Equity volatility has also declined, reflected by the decline in the VIX index.

There is an interesting divergence developing between bond yields, gold prices and the trend in equity markets. Whilst equities continue to go up, bond yields are falling and gold prices are rising. Indeed the usually strong relationship between the S&P 500 and US 10 year yields has collapsed to an insignificant correlation around -0.09 over the past month compared to a high correlation of 0.84 in the month to 8 August.

Rising equities appear to signify an improvement in risk appetite whilst bonds (US 10-year yield around 3.4%) and gold (around $1000 per troy ounce) are giving the opposite message. So which indicator is correct and why the breakdown in the usually solid relationship?

Data releases continue to fail to inspire markets despite the continuing run of better than expected numbers. In the US the Chicago PMI reached the critical boom/bust level of 50.0 in August while the less closely followed Milwaukee PMI surged into expansion territory at 56.0. This revealed some upside risk to the ISM manufacturing index which duly beat consensus coming at 52.9 in August. The fact that positive data is failing to lift markets is a sign of fatigue and stock markets appear to be running out of fuel.

From an FX perspective these developments will not be sufficient to provoke a break out of well worn ranges. Risk trades remain in favour but the momentum is limited. The prognosis does not look as positive for the dollar as the generally improving environment for risk will play negatively. Speculative sentiment (CFTC Commitment of Traders IMM data) has indeed worsened for the dollar; IMM data revealed net dollar short positions increasing sharply in the latest week, with market positioning worse than the 3-month average.

It was a soft end to August overall. Despite a 6.7% fall in Chinese stocks on the last day of the month, global equity markets for the most part registered gains over August. For example the S&P 500 registered a healthy 3.4% increase in August compared to close to a 15% drop in Chinese (Shanghai B) equities. The phrase, “the higher it goes, the harder it falls” looks appropriate in the case of Chinese stocks; at the time of writing, year-to-date the S&P 500 is up around 13% compared to a 68% gain for the Chinese stocks.

Looked at from another angle the S&P 500 is up an impressive 51% from its low in March 2009, whilst the Shanghai index is up a whopping 113% from its low in October 2008. Much of the selling in Chinese stocks as usual appears to be rumour based with talk of more lending curbs in China and a report that China’s state owned enterprises may terminate commodity contracts with foreign banks spurring the initial selling. The law of gravity suggests that Chinese stock may have further to fall.

We are currently moving into an environment where economic data is becoming less and less influential in moving markets, and this could continue for some weeks. The bottom line is that so much recovery news is built in the prices that the continuing run of better-than-forecast data is having only a limited impact. Over recent days, this run has included firmer than forecast readings on US manufacturing sentiment, consumer sentiment, housing activity and durable goods orders. The market has become saturated with good news and is showing signs of fatigue.

Just take a look at the reaction to the latest numbers. Equity markets barely flinched in reaction to positive data including a surge in new home sales and a jump in durable goods orders. In Europe, the German IFO recorded its biggest increase since 1996. Perhaps the subdued market reaction was due to the details of some of the reports, which could have been considered as not as upbeat as the headlines suggested. However, this explanation is tenuous at best.

I must admit it has been quite tough to get a handle on the sharp moves in markets over recent days. Market sentiment shifted from positive to negative and back again in a matter of hours, meaning that anyone wanting to put on a long term trading position has had to have had a significant risk tolerance to hold onto their positions.

Attention was focused squarely on Chinese stocks last week but market fears over tighter regulation eased as the week progressed. Market sentiment was helped by strong existing home sales data in the US, continuing the run of better than forecast US economic data releases. Globally data releases mirrored this tone.

Markets can only be described as fickle as they gyrate back and forth depending on the latest news or earnings report, and as a result, direction is changing not just daily but also intra-day. Investors in most asset classes will continue to focus on stocks, especially the recently underperforming Chinese equity market (Shanghai A share index) which officially moved into bearish territory after falling by over 20% from its early August high.

Various reasons for the drop can be cited including regulators' curbs on the stock market, high valuations, absence of new fund launches, limits on institutional buying, high level of new accounts adding to volatility, tighter regulations on real estate, etc, but whatever the reason the direction has been clearly downwards and the impact is being felt across markets.

The surprise decline in the Michigan reading of US consumer confidence, which dropped to 63.2 in August, put a dampener on risk appetite at the end of last week, helping to fuel a sea of red for most US and European equity markets at the close of play on Friday.

Nonetheless, FX markets remained range-bound, albeit with the dollar taking a firmer bias at the end of the week.

Although many market participants are on summer holiday, this has not prevented some interesting market moves in the wake of yet more improvement in economic data and earnings. The most noteworthy release was the July US jobs report, which revealed a better than forecast 247,000 job losses and a surprise decline in the unemployment rate to 9.4%. Moreover, past revisions added 43,000 to the tally.

Although it is difficult to get too optimistic given that job losses since December 2007 have totaled 6.7 million, the biggest drop since WWII, the direction is clearly one of improvement. Nonetheless, markets were given a dose of reality by the drop in US consumer credit in June, which gives further reason to doubt the ability of the US consumer to contribute significantly to recovery.

News that US Q2 GDP dropped by less than expected, with the 1% fall in GDP over the quarter far smaller than the annualised 6.4% drop in the previous quarter, adds to the plethora of evidence highlighting that the US recession is coming closer to ending.

The bad news, albeit backward looking, was revealed in the downward revisions to growth in the previous quarters, which indicated that the recession has been more severe than previously thought.