Dollar Valuations Built Into FOMC Cut?

This week brings the FOMC rate decision, and the expectancy of another cut in the overnight lending rate from in the U.S. from 1.5% to 1.25%. There are some looking for a cut to 1% and many futures traders looking for a cut to 0.75%.

Whatever comes, the question really needs to be; when will lower Fed rates actually lead to lower mortgage and lending rates? With average mortgage rates pushing towards 6%, at a similar level to when Fed Overnight rates were still at 5%, there looks to be no relief for U.S. consumers and mortgaged home-owners, and that may be the Achilles' heel for the recent dollar rally. The move to the dollar has been in response to global equity markets falling, and the fact that without global inter-bank lending the safest place to be is in U.S. government debt, which like the mortgage rate has not dropped the 10 year Treasury yield in-line with Overnight rate cuts. That USD appeal, however, may get questioned the moment that equities get bought on the strength of a newfound confidence in the financial sector, and the moment that the Libor rate, set by the British Bankers Association, drops and signals that banks are willing to at least start the lending process.

Interest rates have been cut globally; the next part of valuing a currency will be how much lower each region has to go, and which ones will be the first to show growth. It seems, however, that another cut from the Fed is not built in to dollar valuations, and if equities bounce higher sometime this week on the strength of a global adjustment to lending and fiscal policy that the dollar may see some selling as a liquidation of bonds takes place, and forward growth questions get asked. The fact that government debt levels in the U.S. have also been ignored, in the scramble to get under the Treasury blanket whilst the financial sector fall-out takes place, may not so easily be able to be ignored. It may not be a long-term equity rally, nor may it be that the dollar is fully liquidated, but equities look as oversold as the USD looks overbought, and both were bought and sold on fear. Fear and greed work hand-in-hand, one is never too far from the other, as we have seen in the recent global finance melt-down.

Market sentiment is the most fickle of things, and the strength and conviction of equity sellers and dollar buyers may find a day this week that offers a stern test of the courage of their convictions. A stronger dollar is good for overseas holders of U.S. debt, a strong dollar however does nothing at all to help the U.S. economy in its battle to lower the trade balance and current account deficit. If the American plunge protection team is at work it may be that they will look hard at the day that comes when equities bounce higher and hold, because that may be the day Treasuries get liquidated, in just the same way that equities dropped. It may not be tomorrow, may not be this week, but for the dollar to hold near-term values may not be as easy as the climb up to these levels, a climb that was driven by pure fear. Greed may be the thing that counters the recent dollar moves; as fear disperses, greed will show itself once more.

The fact that the U.S. is holding so much debt may allow the dollar to move lower to test near-term support areas, with signals coming from oil holding around $65 a barrel, gold getting back above $750 an ounce, and equity markets trading two global sessions in the green. However small the gains are will be irrelevant for stock traders, just the ability to negate recent selling may be enough to move the dollar to near-term support.

Comments

[Lou Thomas:]

The issues that you raise are reasonable, but the trigger point is still fairly far in the future, so far as economic stabilization and the end of deleveraging are concerned. Dozens of hedge funds are still to fail and disgorge their assets into the mix, repatriating dollars in the process whenever foreign assets are sold.

I agree that the dollar is an animated corpse, jerked upward by deleveraging, without sufficient fundamentals to give it sustainable viability. But that deleveraging is still going on, and so the dollar still twitches. As for equities being over-valued, Nouriel Roubini opines that the markets could fall another 30 percent, and bases his conclusions on price/earnings.

Yesterday's rally is weird and unwarranted. Maybe something to do with the election? Nobody can seem to figure out what is causing it. Some combination of coming rate cut and Plunge Protection Team, perhaps...? Whatever it is, it will not last long. The Dow futures already are at negative 2 percent prior to Wednesday's open.

Whenever the market jerks upward briefly, as it did Tuesday, we see a pause in deleveraging, and the dollar trends downward, as does the yen. That gives a preview of what might happen when deleveraging actually ends. But that has not yet occurred.

It seems to me that bond liquidation could occur by foreign creditors (e.g., China) even without an rally in equities. If China has less incentive to export to the U.S. because of the tapping out of the U.S. consumer, and needs to start building its own middle class, it could take some of its dollars and try to spend them on its own population. I would guess that before that occurs they'll buy up everything in sight that they might possibly use through their SWF, a process that does not push the dollar downward so long as those selling the assets are doing so to get cash to pay dollar-denominated debts (i.e., the dollars they convert to euros or whatever to buy assets from distressed firms will get converted right back into dollars to pay the sellers' debts).

Frankly it is depressing to see everything falling apart so rapidly. Nobody really knows how this will turn out, and but here's my contribution to the confusion.

2008 Oct 29 05:16 AM