Dollar Finds Depreciation In-Line with FOMC Stimulus, Where To Now?

The biggest fundamental threat/catalyst the dollar has faced in months has come and gone. The FOMC rate decision last week held significant sway over the future of the greenback as evidenced by the market’s drive on the mere speculation of what impact a second stimulus program could have on the economy and currency. That said, policy officials were obviously aware of the influence their decision could have on a highly leveraged market. After polling the primary dealers that participate in Fed market operations and Treasury auctions, the central bank announced an $850 to $900 billion in government debt purchases over the coming eight months. This may seem more expansive than the popular $500 to $600 billion consensus; but the breakdown shows they are only planning $75 billion lot purchases each month over the period and setting a range of $250 to $300 billion through the reinvestment program which was already underway. Therefore, this is generally an in-line outcome. So, where does the market go from here? Presumably, this shift was priced in before its actual release. However, the notion that the Fed is leaning heavily towards stimulus will present a constant weight on the greenback. To counter this bearish drift, a fundamental crosswind is needed. The G20 is a potentially topical driver should there be a coordinated effort to stabilize the dollar. More likely, risk aversion has the greatest potential – particularly if it is borne from a European financial crisis.


A Closer Look at Financial and Consumer Conditions



We continue to see a divergence between asset prices and the prevailing sense of financial stability. Under normal circumstances, we would see financial markets accurately reflecting the potential for investment threatening ripples. That would be the case today if there weren’t so many distorting factors to artificially stoke speculative interest. With the Fed’s effort to pump stimulus into the system, they are leveraging the accessibility of capital to speculators and offering an implicit guarantee to support the markets should conditions deteriorate. However, in the background, we see economic activity slowing, the US housing market is threatening a new financial crisis through foreclosures and stimulus itself is being horded at banks. There are exogenous risks as well.



Though the focus from the FOMC decision this past week was on the stimulus program; there is far more than a speculative slant to this policy. In pursuing such an expansive policy, the central bank has risked inflation and other warping side effects theoretically to encourage a recovery in employment (one of the bank’s two primary benchmarks along with inflation). Indeed, we see that the group noted that progress towards growth was “disappointingly slow” and that joblessness was more firmly set than the felt comfortable with. That said, the broader economy looks to have found some level of balance. Now the argument becomes whether additional stimulus will actually translate into growth. Many Fed members doubt it will be a significant gain. This will be an ongoing argument as US GDP eases into the first half of 2011.




The Financial and Capital Markets


Speculativeoptimism was fueled into the FOMC’s November rate decision. For savvy fixed income traders, the purchase of Treasuries offers a very direct front running opportunity. More importantly, for the majority of market participants, the stimulus effort lowers interest rates, expands the money supply and offers a tacit guarantee of government support for rising capital markets. Through reduced lending rates and increased money supply, the net effect is reduced costs for leverage which encourages a buildup in speculative activity. As for the guarantee, a flexible and long-duration (the Fed is targeting investments with a maturity of 5-6 years) program suggests the central bank will ratchet up support should the markets start to sour. So, while there is a very clear economic explanation for the Fed’s efforts; it can be argued that the central bank’s primary objective is to target asset prices and help out the economy indirectly. That strays from their official mandate and quickly becomes a battle even the world’s largest monetary authority cannot fight. If investor sentiment sours globally, the wave will easily be too large for the central bank to hold back. In the meantime, we turn our focus to the questionable progress to be made by the G20 and the recent surge in European government bond yields as the word “crisis” starts to return.


A Closer Look at Market Conditions



If the Federal Reserve is feeding the capital markets, then why not leverage your risky positions? In the September and October, the promise of stimulus and the desire to front run the actual announcement of such support pushed all risky assets higher. Yet, given this aggressive move and the essentially in-line outcome for one of the biggest speculative events of the year, it is reasonable to step back and reevaluate the stability of these aggressive bull trends. This past week, we have seen the benchmarks (S&P 500, commodities) show a very modest correction as debate picks up. Will confidence truly support though? We will soon see.



Once again, we are not seeing an accurate representation of the risks that would naturally accompany such a remarkable rally in capital markets. It is important to note that if risk trends were highly accurate, there would be no room for speculation; and no individual would rally make any market because that would denote a constant fair value is being represented in current price. So, where do we look for our signs of risk? Asset prices themselves are concerning. Multi-year – and under some circumstances, record – highs should clue us into trouble. At such extremes, we would expect an extraordinarily robust outlook for growth and yields. We do not have that. Keep an eye on the tolerance for Treasuries, European Debt and currencies.