BRIAN DOLAN<br /><strong>CHIEF CURRENCY STRATEGIST, FOREX.COM</strong><br /><br />OVER the course of this summer my colleague Jane Foley and I have been consistently cautious on the extraordinary rebound in risk appetite and the accompanying rally in virtually every risky asset class (stocks, commodities and carry trades in forex). We argued that markets were overly optimistic about the prospects for a quick recovery and were underestimating how hard consumer spending and capital investment had been hit.<br /><br />It would be the understatement of the year to say that the 50 per cent plus rally in many stock indices and the doubling of many key commodity prices since spring overwhelmed our expectations. However, as the summer draws to a close, markets appear to be taking a second look at the risk rally and whether it is justified given the weak fundamentals, and struggling consumers and households in particular.<br /><br />The most recent rally coincided neatly with the start of the second quarter earnings season and was fueled by consistently better results from key corporations. (For Elliott wave followers, it also looks to be a Wave 3 advance from the February to March lows.) In the US, of the 90 per cent of the S&amp;P 500 that reported, 76 per cent of firms beat estimates and only 23 per cent fell short. But a closer look reveals that cost-cutting drove profitability, and top-line sales continued to struggle, which provides a clear justification to temper risk appetite.<br /><br /><strong>DEMISE AVERTED</strong><br />Inter-market correlations continue to dominate current market movements and we expect this to remain the case in the months ahead and the trajectory of the US dollar remains a barometer for overall risk appetites. Along these lines, the demise of the US dollar looks to have been averted as G20 officials outside the US have vocally opposed further appreciation in their own currencies. International reserve managers also appear to be supporting the buck as part of an implicit commitment to fund US deficit borrowing requirements.<br /><br />While the US fiscal deficit has obviously exploded, the US is not alone in running mind-numbingly large multi-year deficits, so there's no decisive negative for the US dollar there in our view. In contrast, the US trade deficit has shrunk to about 40 per cent of record levels seen in July 2007, arguably providing the greenback with more stable footing. As risk appetites retrench, the US dollar looks set to perform better in the months ahead and if correlations persist, a stronger dollar augurs poorly for risk markets overall. The primary FX risk trade &ndash; long carry trades &ndash; will remain an important indicator of sentiment, and is also showing signs of exhaustion.<br /><br />Oddly enough, the timing of this risk pullback comes as fundamentals on the ground are poised to begin showing real improvement in many of the largest economies over coming months. In the US, the pace of job losses has clearly peaked, though there's no sign of any hiring increases. Extreme inventory draw-downs suggest a pick-up in third and fourth quarter industrial production, while the US stimulus package will contribute even greater support in the quarters ahead. In Europe, a surprising return to growth in France and Germany in the second quarter suggests an earlier resumption of growth than previously expected. <br /><br /><strong>EXTRA MILE</strong><br />In the UK, the Bank of England has gone the extra mile by extending its asset purchases to hold retail lending rates down, housing prices have stabilised markedly, and manufacturing and consumer sentiment have rebounded, in some cases into expansionary levels. Even Japan managed to post a positive quarterly GDP reading in the second quarter.<br /><br />The fundamentals suggest a more viable improvement in the months ahead, but downside risks remain for sure. Against this backdrop, investor sentiment appears to have hit a wall of exhaustion, but that's more a function of sentiment and price levels rather than rational expectations over future developments. I think this disconnect in timing offers an opportunity to reload on risk assets from more advantageous levels, but as always, timing is everything.<br /><br />If key asset markets have indeed just gone through a third wave advance, this fall may play witness to a fourth wave correction, which is typically a choppy, messy affair. Incoming data reports will likely reflect such unevenness, making for volatile trading conditions ahead.<br /><br />In anticipation of this, I would suggest paring back risk exposures, but ultimately using excessive risk market pullbacks to re-build risk positions for a more sustainable global recovery in the months ahead.<br /><br />