The US Dollar made solid headway higher on Monday, but with little fundamental impetus other than simple short covering following the uneventful G7 meeting, the move highlights the speculative nature of the markets.
Fed fund futures currently price in a 86 percent chance of a rate cut by the Federal Open Market Committee on October 31st, up from 78 percent this morning but down from 92 percent on Friday. At this juncture, the central bank has been giving very mixed signals, as their previously hawkish stance has been toned down significantly and instead has shifted to focus on economic conditions. Furthermore, while the health of the financial markets is clearly of importance to the Federal Reserve, the matter of whether the bank is essentially “bailing out” the stock markets and companies that irresponsibly got caught in the borrow-short-lend-long squeeze during August is still being debated. Indeed, when the Dow plummeted more than 2 percent last Friday, expectations of a 25 basis point cut at the end of the month rocketed higher. What about that pesky inflation issue? Headline CPI has climbed to an annualized rate of 2.8 percent on the back of food and energy prices. However, energy prices aren’t just high – oil continues to trade near record highs – and food prices haven’t ticked up – wheat futures rocketed to a record in September. Nevertheless, Federal Reserve Governor Frederic Mishkin said over the course of the weekend that core inflation measures, which exclude food and energy costs, are a “better guide” as they “provide a clearer picture of underlying inflation pressures.” With core CPI holding relatively steady at an annualized rate of 2.1 percent, Mishkin’s comments suggest that the FOMC potentially has more room to cut rates. However, it is worth noting that core CPI also happened to be stable at these levels throughout late 2004 through early 2006 – the same period of time that the FOMC was aggressively raising interest rates. As a result, there may be good reason for all this confusion over the Fed’s policies, especially as additional rate cuts may confirm one of the biggest fears of the markets: the potential for another August-style credit crunch may be greater than many would like to believe.