Dollar May Drop Without Action From The Fed

Published August 21st, 2008 - 02:04 GMT

Last week, the dollar closed its fifth consecutive week in the green – the currency’s strongest run in more than two years. However, this rally may soon run out of steam if the Fed doesn’t boost the greenback’s appeal.




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CREDIT MARKET: HOW IS IT DOING?

Last week, the dollar closed its fifth consecutive week in the green – the currency’s strongest run in more than two years. However, this rally may soon run out of steam if the Fed doesn’t boost the greenback’s appeal. Caution has clearly turned the currency market to congestion this past week as FOMC rate expectations show a slimmer probability for rate cuts in the new future. Fed Fund futures are pricing in an 88 percent probability of no change to the 2.00 percent benchmark lending rate at the September 16th policy meeting. However, looking out over the coming year, the markets seem to be assured of at least one quarter point hike. Regardless, speculation can have only so much sway over a market without the actions to back it up. If the Fed doesn’t at least indicate the votes are becoming more hawkish, problems with growth and the financial market will sap the dollar’s strength.



A DEEPER LOOK INTO THE CHANGES THIS WEEK:

Lending and credit is under the gun once again. This past week, there were two headlines that have put the pinch on liquidity and casted doubt over the health of the seemingly fragile banking system. Adding to the pressure of massive writedowns, banks are now being forced to buy illiquid auction rate debt back from clients by the billions. Either this will need to be held for a loss or pushed onto an already overloaded market. The other issue is the growing speculation that Freddie and Fannie won’t make it without a government bailout.  

Short-term paper has spent another week largely unmoved. With economists forecasting a strong revision to the 2Q GDP figure and little chance of a rate hike from the Fed anytime soon, investors have not flooded back into the relatively riskless money market products to avoid a possible Freddie and Fannie collapse. On the other hand, musings by an ex-IMF chief that a major US back will go under in the near-term future could easily turn the market on end. In fact, if any of these fears finds life, liquidity could once again vanish.





FINANCIAL MARKETS: HOW ARE THEY DOING?

The rebound in US capital markets has stalled through this past week. Though the advance in benchmark equities markets was choppy to begin with, a few strong down days have clearly cooled the potential for a bull market based on momentum alone. Looking at the developments in surrounding markets, it isn’t surprising to see this happen. The swift drop in key commodity prices (a factor that boosted growth expectations as well as business revenue forecasts) has found a tough level of support. The investment outlook continues to deteriorate thanks to deteriorating consumer spending and residential market activity. These issues are made all the more dramatic with the foundation of the financial markets in jeopardy. Accumulated losses from major banks and consumer lenders have raised speculation that another Bear Stearns-level failure is inevitable and Fannie Mae and Freddie Mac will be forced to seek capital from an ever-more frugal investor.
A DEEPER LOOK INTO THE CHANGES THIS WEEK:

While the ground gained from the July rebound hasn’t been fully retraced, the bullish convictions of the market have been broken. A smattering of earnings data has crossed the wires with losses that reflect difficult lending conditions and a fading consumer wealth and confidence. More stirring for fundamental sentiment however was the trouble in the financial sector. Auction rate debt buy backs seem to be the new CDS write offs; and it is getting more difficult to raise capital. Market condition indicators have been somewhat mixed during this period of high speculation and relatively low action. Reflecting the otherwise orderly pull back in equities, the VIX volatility index has slowly risen back above the 20 percent target level without gaining much momentum. On the other hand, a bear market seems to be a fact accepted by portfolio managers. The put-call ratio has jumped back up to 2.27 as protection grows more expensive than additional returns in purchased calls.


U.S. CONSUMER: HOW ARE THEY DOING?

Similar to the extreme rally in the US dollar, the sharp drop in consumer confidence seems to have hit a level of equilibrium. This past week, the University of Michigan’s consumer confidence reading for August rose for a second month from its multi-decade low through June. This rebound has come through in improvements to the economic outlook as well as the forecast for inflation trends (though current conditions are still considered quite bad). The inflation forecast will be key going forward as Americans have just started to see wage growth contract and unemployment rise. With housing equity essentially out of the picture and credit tapped, spending will rely on perceptions of affordability. In this, the pull back in interest rate forecasts from 5.2 to 4.8 percent is encouraging; but with CPI hitting 17 year highs and upstream core PPI at similar highs, even this bright spot may fade.
A DEEPER LOOK INTO THE CHANGES THIS WEEK:

Timely consumer data is maintaining its pressure on a near-term rebound in the world’s largest economy. Somewhat complementary to the U. of M. survey, the ABC sentiment gauge rose for the first time in seven weeks with the first pick up in the economic outlook in some time. On the other hand, the figure is still hovering near multi-decade lows, so this turn hardly brings the American consumer to optimism. For the evolving deterioration in employment, jobs continue to disappear in the government’s week-to-week data. A modest improvement in initial jobless claims can’t cover for a five year high in total claims. The longer-termed economic data that crossed that has crossed the wires since our last update lends little validation to forecasts of a strong revision in the 2Q GDP numbers – much less sustained strength through the second half of the year. Consumer confidence has merely ticked higher from generational lows and price growth continues to wear down purchasing power anyway. Add to this the non-stop weak readings for the housing market. Foreclosures have jumped 55 percent year-over-year as mortgage rates rise. With this in place, housing starts have dropped and building permits (a gauge of future construction) for single family homes dropped to a 26-year low.


Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

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