Dollar Could Be Troubled By Rate Cuts Even If Bailout Goes Through

On the eve of the second Congressional vote for the US bailout plan, dollar traders have a singular focus on the stability of the financial markets. However, even after the crisis has been put to rest, it won’t take long before the realization that a recession and rate cuts are likely on the way sets in. Over the past few weeks, the failure of major banks and complete seizures of the credit market have necessitated the undivided attention of policy makers and investors. A distant after thought is the second round effects of this turmoil; and that is a potentially accelerated recession. With growth and inflation figures cooling quickly in the background, the forecasts for rate cuts read in Fed Fund futures are well supported. For the meeting on the 29th, there is a near 100% chance of a 25bp cut and 46% probability for a 50bp easing. Expectations for December are far more dovish.

In the hierarchy of priorities, the normal functioning of the credit and financial markets for traders is the equivalent of air to humans’ existence. However, when that need has been satisfied, market participants then must consider the health of the economy and the environment for investment. Looking at data over the past few months, the outlook for growth is certainly dour. With a housing recession and slow down in business activity already in place, the biggest threat to the economy is consumer spending. Therefore, with unemployment rising quickly and wages fading, hope for a rebound is fading.

Credit and lending conditions are as volatile as ever. Though the overnight lending rates (LIBOR) pulled back from their record advance following the initial voting down of the bailout plan, the dramatic swings certainly damages confidence on its own. Aside from this, demand for short-term and deeply liquid funds remains near multi-year highs. The relative safety of 3-month T-Bills is evident in the depressed yield; but it will be important to see how things evolve if the government agrees to further leverage its already enormous debt load. At the same time, fear has launched Libor rates even as demand balloons.

While dramatic fluctuations in price action seem to have been dampened in the US capital markets, fear is still very high and values depressed. The bailout is taking front and center for fundamental concern; but growth seems to be a bigger factor in the more traditional investment arena. The toxic debt on balance sheets is primarily an issue for the banking and lending sectors; but recently the implications have sunken deeper into the perceived health of the economy. In effect, this ongoing financial crisis has merely exposed the proximity of a genuine recession – which will hit regardless of whether Congress approves a stunted bailout plan or not. Nonetheless, should credit conditions return to normal (for good), it would alleviate the constant pressure on risk appetite. So, while it may be difficult to find a good investment during a possible recession, traders will nonetheless put their capital in the markets to find it.

Day to day, traders in the capital markets are merely looking for reprieve from high volatility. Returns seem to be a second concern to overwhelming risk. Fear is still very at extreme levels with the benchmark VIX index holding just below 40%. This is also reflected in price action with the benchmark Dow 30 just off three-year lows. In the background though are the growing expectations of a US recession. With activity slowing around the world, commodity demand and price has plunged.

Risk appetite is in cardiac arrest. As media outlets and economists warn of the dire future for the markets should credit freezes and bank failures persist, investors have desperately sought safety in liquid assets and shaky insurance. A reflection of risk aversion and demand for safety, the Junk Bond spread has held near recent record highs. Used to hedge against catastrophic losses, credit default swaps have seemingly stabilized off highs – awaiting any word of a confirmed bailout.