Dollar Advance May Taper As Speculation Of Fed Cut Resurfaces

DailyFx · September 10, 2008, 4:10pm

The dollar pushed to an 11-month high today as crude prices approached $100/barrel and fears in the financial sector were quieted. However, dark clouds are gathering.

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The Economy And The Credit Market

         The dollar pushed to an 11-month high today as crude prices approached $100/barrel and fears in the financial sector were quieted. However, dark clouds are gathering. While other fundamental drivers may be sustaining the short-term drive, Fed forecasts may ultimately decide the dollar’s fate through the end of this year. With consumer spending threatening to send the US economy into a genuine recession through the second half and the financial sector averting monumental crashes through government bailouts alone, traders are seeing greater (albeit modest) scope for the FOMC to turn once again to rate cuts. Looking out to the December 16th meeting, Fed fund futures are pricing in a 19 percent chance that policy makers could cut 25 basis points to 1.75 percent. Overnight index swaps confirm these fears. For reference, the last time we saw such dour forecasts was in April.

A Closer Look At Financial And Consumer Conditions

         While many of the earth-shattering headlines that have crossed the wires over the past weeks have ultimately been folded into the dollar’s rally; the long-term implications will not be so easily forgotten for the US economy. Unemployment has risen to a 5 year high and American consumers are already struggling with reduced spending and uncontrollably high levels of credit. Furthermore, an ongoing credit crunch threatens to depress business investment and keep the housing recession on pace. Though these concerns are still relatively obscure in pricing, economists, policy makers and traders are slowly coming to realize a US recession may be in store for the second half.

                                   

         

         Two major events seem to have passed with a sigh of relief from the capital markets and policy makers; but credit conditions suggest lenders haven’t been reassured. So far this week, Fannie Mae and Freddie Mac were bailed out by a reluctant Treasury Department and Lehman Brothers seemed to avert a massive client withdrawal after stepping up 3Q earnings and announcing cost cutting steps. Looking at the real impact the government acquisition had, we saw Treasury defaults hit a five month high as the debt load curbed confidence in all US assets. Also, the Lehman has hardly revived itself, and the bank ‘watch list’ is very long.

The Financial And Capital Markets

         There is clear conflict in the capital market between short-term reassurance and long-term growth fears. Keeping the benchmark equity and bond yield indexes buoyant so far this week, the FHA’s takeover of the United State’s two largest lenders (accounting for nearly 50 percent of all mortgages) has cooled fears that lending would seize and access to credit would disappear. What’s more, key commodity prices have maintained their steady descent. Despite news that OPEC would be cutting production and Hurricane Ike was passing through the Gulf of Mexico, crude has steadily moved towards $100/barrel. This certainly removes one of the key weights on global activity going forward. However, with a number of the world’s largest economies looking at recessions, there is more than enough reason to move out of risky assets. The US, Euro-Zone and UK are three major industrialized economies expected to be suffering from recession by year’s end.

A Closer Look At Market Conditions

         If we were going by the general sentiment read in the media, then confidence has been restored by the Fannie/Freddie bailout and Lehman earnings report. A more realistic look is seen in price action. The S&P 500 has not recovered and financial sector was still down 7.6 percent on the week. The volatility gauge above 25 percent is also a reliable gauge of trader sentiment. In the end, both of these events have merely pushed back growing problems with the credit market and a slowing economy.  

                                   

         

         In other markets, there are also signs of a drop in demand (but not necessarily risk). In the currency market, the carry trade unwind continues. With global interest rates contracting and asset volatility rising, the yield dependent strategy has fallen to its lowest levels in over two years. Elsewhere, even the pull back in commodities may have an unwinding component to it. While it is hard to determine what level of influence speculative funds had on the run up in energy and other raw material prices, it was nonetheless a factor in the surge to record highs.