On the Dollar Index and Financial Sector

Dollar Index

It was fascinating to see the dollar's remarkable run to the upside as traders come to the realization that a global slowdown is occurring and that a number of economies are now threatened by the specter of recession.

If the dollar is to appreciate further, it will do so in part on the sentiment that the U.S. is better-positioned to weather the financial storm by virtue of the Federal Reserve remaining the only central bank with negative real interest rates.

It also now appears that the Treasury's plan to backstop mortgage giants Freddie Mac (FRE) and Fannie Mae (FNM) represent a turning point not only for the dollar, but for equity markets and commodities as well.

We believe that dollar valuations are also being driven by the needs of other economies to devalue their currencies in a race to compete in world markets so even if central banks in the U.K. and Europe cannot actually lower borrowing costs now, they certainly want to see their exports become more competitive. A nation is like a store; when demand slows, prices are lowered in order to attract customers and as the global economy slows, we are likely witnessing this simple economic law play out on the grandest of scales. On the day, the index gained 1.257 (1.69%) to  75.804.

The Financial Sector

The news that Fannie Mae posted a fourth straight quarterly loss was one thing; worse was the mortgage giant's outlook on housing. The GSE announced it would stop buying no or low-doc Alt-A mortgages by the end of the year in part because it believes the deepest housing slump since the great depression is worsening. As a result, the net effect here can only serve to decrease credit availability in a market that is already seriously constrained while the limitation of capital pushes mortgage rates even higher.

It also means that the pool of potential borrowers has grown smaller even as the available inventory expands, further upsetting the supply/demand imbalance which can only serve to depress housing prices in the medium term.

Because neither Fannie or Freddie are properly provisioned against further credit losses, it seems as if Hank Paulson's plan to buy unlimited equity stakes in the companies and/or extend them financing will need to be put in effect.

Bill Gross of PIMCO was estimated that the Treasury will be forced to buy as much as $30 billion in preferred stock in both firms. Shares in the company closed down 9.05%.

On this day however, the fall in oil was more than enough to offset the bad news regarding the GSE, and the Financial Select SPDR ETF (XLF) closed on 21.94 after gaining 0.73 point (3.44%) on volume of 176,792,472, 2.5% above the daily average of 172,199,000. Volume in the XLF has increased nearly 70% on a daily basis since the beginning of July.