commodity prices crashing down around our ears

Foreign Currency Exchange Outlook : For the price of oil to continue south despite lower US stocks and despite a hurricane headed for the Gulf Coast implies extreme bearishness about the global economy. For gold to have fallen to the lowest price in a year implies a spreading fear of deflation. Declines in both oil and gold suggest that investors and speculators are getting more interested in recession-proof assets. For the financial sector to be leading global stocks downward means investors are starting to batten down the hatches.

All of this suggests that bonds should be the flavor of the day and we can’t expect yields to recover as long as fear is ruling. Since the US is the safe-haven bond of choice these days, the dollar can only gain as these trends gather momentum, which is nice for the dollar but an unhappy development for the Fed. The Fed would prefer to see rising yields since that helps the banking sector, which can get deposits cheaply and in the worst case scenario (a drop in lending), just buy Treasuries for a nice spread. Now that banks are de-leveraging and foregoing fees on iffy “products,” recovery in the financial sector should be painfully slow.
Longer run, of course, the US dollars “should” have a higher relative real yield, but for the moment, foreign exchange traders and investors are willing to overlook that. Look at pound to Japanese yen if you don’t believe it. Risk aversion has a powerful grip and can overcome even the juiciest of carry-trade spreads, at least sometimes.

That brings us to the question of whether the Fed would consider a rate cut on the grounds that a rising dollar is the same thing as tightening credit conditions. This is muddied by banks being unwilling to lend for reasons other than credit quality. Also arguing against a rate cut is the high inflation rate in the US, technically over 5%, although the Fed might argue that with oil and other commodity prices crashing down around our ears, we have to forecast falling inflation. (Note that we get fresh inflation data next Tuesday, although they are lagging and will not reflect the recent drop in commodity prices.)

Some observers imagined that Yellen, in remarks last week, suggested that ever-rising interest rates are not a foregone conclusion. We didn’t see it that way, but her comment was ambiguous. Nobody expects the Fed to take any action at next week’s policy meeting, but it’s conceivable, just, that we could get a more balanced outlook in the press release. If the Fed were to say the outlook for inflation has improved by a lot, it could put a serious dent in dollar’s uptrend. That would imply the Fed willing to ease while the ECB is still in full-dress hawk mode. It’s probably a remote possibility and yet we can detect the faintest whiff of such risk.

The most interesting aspect of it is where it leaves the UK, which seems to be siding (so far) with the ECB on fighting inflation and to hell with the fading domestic economy. The Bank of England seems to think it is stuck with falling activity and rising inflation and unemployment, but because it can see light at the end of the tunnel (in 2010), no rate action is appropriate.

Well, they are entitled to their opinion.

At this point, the deflation scenario has not yet captured everyone’s imagination. The market is in the grip of the chartists, and chartists have as their first principle the observation from Charles Dow that once a trend is in place, we expect to remain in place until something Big comes along to disturb it. Any suggestion the Fed might cut rates could be Big, but then again, maybe it’s not, since it doesn’t necessarily flatten the yield curve. Besides, lower rates promote whatever lending is left to get done, cheer up the stock market, and would show the world that the US is still on a growth path and not headed into technical recession. Most of all, it would show that the US is pro-active, unlike others. It’s a bit bizarre to say so, but a rate cut or rate-cut talk from the Fed next week would probably be dollar-favorable! And even if the Fed refrains from saying anything remotely lucid about rate levels potentially going down, we are pretty sure it will be increasing liquidity to financial institutions at quarter-end and year-end, which is almost the same thing, if without the announcement effect.

Today is the anniversary of the 9/11 attacks on the World Trader Center and Pentagon. Is there increased wariness and nervousness? Yes, probably, but it’s unwarranted. It’s those of us in the Western mode who think in terms of higher risk on an anniversary.

We have no evidence that the bad guys think that way, too.

Bye for Now

Barbara Rockefeller

Best Exchange Rates when you Buy US or Canadian Dollars