Dollar Rally Flagging As Fed Hike Forecasts Fade

Published August 14th, 2008 - 03:27 GMT

Threatening the longevity of the dollar’s recent momentous rally, Fed Fund futures reveal the probabilities for a rate hike this year continue to dissipate. For the next rate decision, on September 16th, futures show an 85 percent chance that the central bank will hold the benchmark rate at 2.00 percent – compared to a 76 percent probability this time a week ago.



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CREDIT MARKET: HOW IS IT DOING?

Threatening the longevity of the dollar’s recent momentous rally, Fed Fund futures reveal the probabilities for a rate hike this year continue to dissipate. For the next rate decision, on September 16th, futures show an 85 percent chance that the central bank will hold the benchmark rate at 2.00 percent – compared to a 76 percent probability this time a week ago. Through the end of the year, the shift in forecasts has been more dramatic. From last week when traders were betting there was a 44.3 percent probability of no change, the market is now looking at 68.2 percent likelihood. This shift is no doubt based in the disappointing outlook for growth for the world’s largest economy and the recent rebound in credit concerns. With the dollar now hesistating after a trend altering rally, interest rates could redefine the greenback’s future.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

Risk aversion has reared its ugly head. Over the past week, news has hit the wires that suggests banks’ losses from the subprime meltdown may be far greater than many market participants and commentators had initial expected. Most concerning was a letter issued by a consortium of top banks suggesting a greater investment in risk management, increased regulation and limiting investment in credit derivatives. If businesses are suggesting steps to cut into their future revenue stream, conditions must be dire indeed.

For credit markets, the rise in risk aversion isn’t as apparent as it has been in the carry trade. Short-term paper has seen rates holding relatively steady, and it could stay this way until warnings start to bear unwanted fruit. Liquidity is already suspect with Citi and Morgan Stanley announcing they will have to buy back $19.5 billion and $4.5 billion in auction rate debt from clients respectively. The outlook is far worse. Moody’s has forecasted a 10 percent default rate on speculative grade bonds – much of which is held by banks.





FINANCIAL MARKETS: HOW ARE THEY DOING?

US capital markets are still volatile this week; but direction has certainly grown mixed. Through the benchmark equity indexes have risen week-over-week, the advance has been choppy. The same can be said for the corporate bonds. This unstable move has been the result of conflicting pressures in the market. On the one hand, commodity prices have plunged over the past few weeks. In fact, crude prices (the life blood of any economy) pulled back from a record high last month to below $114 per barrel. During this move (or more likely cause for it), the dollar has also revived confidence in US assets by appreciating against all its major counterparts. However, throwing the break on this promising run, rekindled fear in the credit market and a dour outlook for second half growth have keep bulls in check. While GDP bounced through the second quarter, fading employment and wage trends (along with falling home equity) is clearly weighing on spending expectations.

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

While the benchmark stock indexes made their choppy advance, the major market components have taken take a very different path. Consumer-related firms have seen shares fall only modestly through the week as discount giants like Wal-Mart offer American’s access to their necessary goods. On the other end of the spectrum, the financial sector has plunged since last week as banks are taking another hit – not from write downs but from forced buy backs of auction rate debt.

Though volatility in underlying equities is relatively high, market condition indicators have been relatively placid. The uneven advance from the Dow and its fellow benchmark stock indexes has led the S&P 500 put-call ratio to new multi-month lows as traders continue to shun protective puts and instead by calls to take advantage of the rebound. At the same time, the VIX has risen, but only modestly. Still holding close to the 20 percent mark, volatility is still well of the mid-July highs.





U.S. CONSUMER: HOW ARE THEY DOING?

The outlook for the US economy can’t be revised by the rally in the dollar. Alone, the drop in crude prices holds considerable promise for gasoline prices; but this one cost cannot compensate for the significant hurdles arising for consumer spending (the largest component of GDP) in the near future. Employment is quickly becoming a significant issue after continuing jobless claims rose to a four-year high, maintaining the growing concern surrounding the rise in unemployment. Wealth is another matter as home values continue to drop and now wage growth begins to taper off. Then, bringing the consumer full circle, prices for necessary goods continue to rise. This past week, we have seen a 0.1 percent drop in retail sales and jump in the dependence for credit. If consumers grow more concerned about the economic outlook (along with their financial position), the consequences could be significant.  

A DEEPER LOOK INTO THE CHANGES THIS WEEK:

Timely consumer-related indicators have reminded the market why the economic future of the US is in doubt. For confidence, the ABC sentiment gauge dropped to a -50 reading through the past week (just off the record low set back in May) as the measures for personal finances and the buying climate deteriorate. Contributing the dour sentiment, MBA mortgage applications slipped 1.5 percent as the average 30-year fixed-rate mortgage jumped from 6.57 from 6.41 percent due to the recent bank concerns. Far more concerning though was the jump in initial jobless claims to a new six-year high 455,000. With numbers like these, its hard to spot a turn in NFPs.

Economic data has come across the wires relatively mixed over the past week. From the consumer side, the IBD confidence gauge for August rose from a sixth month low, but consumer spending took a major hit with retail sales falling for the first time in six months and the ICSC chain store sales report cooling to a 2.6 percent pace of growth. On the other hand, the top underperforming sectors of the past have shown some level of improvement. Pending home sales jumped 5.3 percent through July while the ever-present trade deficit shrank to $56.8 billion on the biggest jump in exports in four years. However, when everything is said and done, the consumer will guide growth.            

 

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

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