Dollar Vulnerable As Fed Options Limited And Growth Fades

A new year may have begun, but the same fundamental difficulties of 2008 remain for the US economy and its currency. In fact, conditions have arguable deteriorated from just a few quarters ago; and policy officials are quickly running out of options to preventing a full-blown depression and another financial crisis. The first thing that is immediately apparent at the beginning of the year is that the Federal Open Market Committee has its back against the wall. The benchmark lending rate is essentially at zero (cutting the range aspect of the current stance wouldn’t provide any additional support) while the quantitative easing recently discussed has been in place for months and has yet to produce clear results. At the same time, a recent assessment of the economic outlook from the central bank noted “substantial” downside risk to growth and the “distinct possibility of a prolonged contraction.” The last line of defense seems to be the incoming President’s plans for a truly massive economic stimulus plan.

The height of the financial crisis back in October seems to be a thing of the past; but modest improvements to market conditions in thin liquidity is hardly confirmation that things have returned to normal. Indeed, short-term Libor rates are quickly catching up to their risk-free counterparts, but there is still a very visible gap between the lending rates that financial institutions are receiving versus those available to consumers and businesses. In fact, since the Fed instituted its aggressive pace of rate cuts, average loan and mortgage rats have barely budged. This is reflective of ongoing fear on the part of banks as they build reserves to buffer against another credit crunch.  

Recently released data reveals that this past holiday shopping season was the worst in four decades – an ominous outcome considering retailers make the bulk of their annual revenue during that short period alone. This is likely to further encourage firms to shed jobs and abandon planned investments in order to prevent a bankruptcy. What’s more, this will no doubt have a direct impact on employment. National payrolls shrank by more than half a million through November, and the December numbers on Friday are forecasted to see similar losses. From this point on, the consumer holds the reigns on how deep the nations recession will be.  

Activity in the capital and credit markets has picked right back up after the thin holiday period. And, initially, the return of liquidity for the new fiscal year saw a bullish rally as side-lined market participants looked to reinvest their funds. However, this rally is certainly counter-trend. Bearish pessimism is still the dominant force in the market – and for good reason considering the lack of credit available to build leverage and the threat of a deteriorating economy to naturally curb risk appetite. We have already seen the week’s early advances tapper off as grounded fundamentals set in. In looking ahead, investors’ focus will remain on the big-ticket items of the second half of 2008: the possibility for further sector-wide collapses and trying to speculate on the eventual turning point for what may be eventually be the economy’s worst recession in decades.

The return of liquidity has been a boon for the traditional capital markets. As capital that was side-lined to avoid the thin markets and accounting purposes found its way back into the field, prices were naturally boosted. However, until a true trend change (that runs against fundamentals) can be confirmed through normal market conditions, the bearish influence over the market will remain. To leverage a true recovery, investors will have to shake the prevailing sense of pessimism that has accompanied the recession and financial crunch. As economic activity and yields shrink, however, this looks further away.

Taking a closer look at sentiment, there are initial signs that fear and panic are letting up. From the speculators’ perspective, the benchmark S&P 500 Volatility Index (VIX) has pulled back to 40 percent from a record just short of 90 percent a few months ago. Not only does this suggest there is a high probability of dramatic swings in the days in weeks ahead; but more importantly, it points to a thawing in the derivatives market. On the institutional level, the sharp drop in default risk premium calms fears that bankruptcies will send shocks through the credit market. However, we are still at historically high levels for both.