Prices fell after a respected fund manager said global write downs, due to losses in the credit markets, could be as high as $1.3 trillion. This is substantially more than the International Monetary Fund's estimate of $945 billion. One money manager said banks are only "one third through" their credit related write downs.
There was additional selling on news that demands for U.S. architectural services dropped last month, according to the American Institute of Architects. Their billings index dropped to 43.4 last month from 45.5 in April. This leading indicator of the construction industry suggests there will be further pressures on the economy into 2009.
Not all of the news is bearish. There were some recovery gains after a "Washington Post" column said market speculation that the Fed was likely to raise interest rates soon appeared to be "dead wrong." Articles in the "Financial Times" and "The Wall Street Journal" contained a similar theme. In the past, it was thought that the Federal Open Market Committee occasionally telegraphed their true policy intentions in the financial media in the weeks just prior to their scheduled meeting. It appears as though this is what is happening now, since at least three financial publications wrote articles that toned down interest rate increase expectations.
Two important longer term fundamental factors that have supported this market are about to disappear. The bullish influence of the government's stimulus package will wear off later this year. Also, we are predicting that the much heralded U.S. export business is in the process of slowing now that the growth prospects of the economies of Asia and Europe are coming more into question.
It is not only U.S .equity markets that are under pressure. International equity markets hit their lowest levels in almost two months. According to a recent survey, confidence in the global economy fell in June on fears that central banks may increase interest rates in order to fight inflation.
The Fed is fighting a two front battle and only has the resources to fight one at a time. They can either support the U.S. dollar or the stock market. They can't do both.
At this juncture, the Fed needs to be very careful. Too much hawkish commentary, while supportive to the U.S. dollar, could result in a new down leg for equity prices. This is exactly what is likely to happen and we are already beginning to see this unwanted consequence now. For now, they have chosen to support the greenback through the use of "moral suasion" and threats of tighter credit policies. These efforts have been met with some success, since the U.S. dollar has stopped going down in value. While talk of higher interest rates is holding the line on the U.S. dollar, support for the economy and the equity markets have been severely undermined. The Fed and Treasury, especially the Fed, appear to be in a management by crisis mode. It appears that they have been, at least, temporarily successful in their "moral suasion" attempts to support the U.S. dollar. Although all of this renewed hawkish rhetoric from Fed and Treasury officials has had the desired bullish effect on the U.S. dollar, we must now ask a very important question. What is the cost? Tighter credit policies, while very supportive to the U.S. dollar, are likely to be very damaging to the equity markets. Most likely, the next issue that the Fed will be forced to deal with will be falling stock indices and economic weakness.
Continue to trade from the short side on rallies. This bear market in stock index futures is likely to last into 2009.
Prices came under selling pressure as a direct result of recent comments from Federal Reserve Board Chairman Bernanke. His comments suggested the Fed could raise interest rates later this year in an effort to control inflation. The Fed is talking tough on inflation now, but ultimately, when the economy continues to weaken, they will be forced cut interest rates again. Also, there is the growing feeling that the effects of the domestic stimulus package will only be temporary and that there is a distinct possibility of an economic downturn later this year.
Expect much of the hawkish attitude, on the part of the Fed to diminish, as it becomes more apparent that the economy is continuing to weaken. Likely further economic weakness, along with stock index pressure, could very quickly reverse the Fed's hawkish tone to one of accommodation.
While the vast majority of credit market analysts believe the Fed will raise interest rates later this year, our work indicates that there will be no increase in rates. In fact, there is a very good chance that the Fed will be forced to lower interest rates as the economy weakens further. We are very much in the minority by saying that the next change in policy from the Fed will most likely be a reduction in interest rates.
Expect higher prices for Eurodollar futures.
There was some temporary selling pressure in the U.S. currency after the Group of Eight failed to make a strong U.S. dollar supportive statement after a weekend meeting.
The U.S. dollar was able to gain later after Federal Reserve Board Chairman Bernanke increased his anti-inflationary rhetoric. He said the central bank will "strongly resist" any waning of public confidence in stable prices. His comments increased expectations of potentially tighter credit conditions from the Fed.
Some analysts are saying that the U.S. government has made a "major change" in its foreign exchange policy that will improve the fortunes of the U.S. currency. Our view remains that the best the Fed will be able to do is to temporarily hold the U.S. dollar steady. Ultimately, the bearish fundamentals in the U.S. will dominate and cause the U.S. dollar to break out to the downside.
In addition, the euro lost ground against the U.S. dollar after a European Central Bank council member said the bank is not about to begin a new series of interest rate increases. The euro was supported later when other central council members said the European Central Bank will increase interest rates more than one more time this year.
The inflation rate in the euro zone increased to 3.7% in May, which is the highest rate since June of 1992. The April inflation number was 3.3%. Accelerating inflation in the euro zone is the main reason to expect tighter credit conditions from the European Central Bank. At the same time the Federal Reserve, most likely, will leave credit policies unchanged at their June 25th meeting.
Sentiment currently is U.S. dollar favorable. However, this could very quickly change if a much weaker U.S. economy or stock market comes to the forefront.
The long term trend for the euro currency is higher.
The pound was hurt by news that the U.K. services sector unexpectedly contracted for the first time since 2003. In addition, consumer confidence fell to its lowest point in four years, while service companies eliminated jobs at the quickest pace since 1996.
There was some further selling on news that U.K. inflation reached its highest rate since May of 1997. The Bank of England Governor Mervyn King predicted inflation could exceed 4% by later this year, while the Bank of England's Monetary Policy Committee said "it is concerned about the present and prospective period of above target inflation."
The Bank of England kept their benchmark interest rate unchanged at their regularly scheduled meeting even though the central bank predicted inflation levels will advance above their upper limit. The official interest rate remains at 5%, which is the highest of the Group of Seven countries. Accelerating inflation levels will likely prevent the Bank of England from cutting interest rates anytime soon. Normally, higher inflation levels are bullish for a currency because it means interest rates will be increased. However, the pound traded lower, which was opposite to the news and is a sign of weakness.
The Japanese yen continues to under perform. However, occasionally there are temporary recovery gains in response to lower stock index futures. Lower equity prices have a tendency to discourage investors from buying higher yielding assets that are purchased through low interest rates in Japan.
The Japanese yen is likely to remain under pressure over the near term, while there is talk of higher interest rates in the U.S. and in the euro zone.
The Canadian dollar remains firm after the Bank of Canada unexpectedly left their benchmark interest unchanged at 3%. A 25 basis point cut had been anticipated by all 30 economists surveyed prior to the meeting.
The Canadian dollar was also supported by news that Canada's annual inflation rate increased to 2.2% in May from the 1.7% increase in April. Higher inflation rates pushed interest rates up, which in turn, is attracting funds from overseas.
Higher commodity prices have recently supported the Canadian dollar, as well.
Expect prices for the Canadian dollar not to follow through in either direction as the effects of a steady interest rate policy are offset by the bearish influence of a weakening Canadian economy.
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The Australian dollar advanced after the Australian GDP report grew twice as fast as analysts had expected.
There was only temporary pressure in the Australian dollar after it was reported that, according to the Bureau of Statistics, companies eliminated 19,700 jobs in May. The median guess called for a 13,500 gain. This was the first drop in employment since October of 2006.
The Australian dollar remains strong due to a relatively hawkish Reserve Bank of Australia interest rate policy, while their benchmark interest rate remains at a very high 7.25%. This high interest rate continues to attract funds from overseas.
Expect further gains with the next objective at a one to one parity to the U.S. dollar.
Questions or comments about this article, please contact Alan Bush at 1.800.243.2649 or email at alan.bush@archerfinancial.com.
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