Dow at 10,000 Could Mean Dollar/Yen at 100
On Friday, the idea of the Dow hitting 10,000 seemed to be a remote possibility, but today, that is starting to become a reality. We have warned on a near daily basis about the danger of carry trades. Although the EUR/USD’s reaction to the systemic risk in the financial markets was not as clear, there was a clearly negative implication for USD/JPY. Not only did we talk about the 70 percent correlation between the S&P 500 and USD/JPY, but there is also a similarly tight correlation between USD/JPY and the VIX index, which measures the volatility of the stock market. This means that the weakness in stocks and the rise in volatility drove USD/JPY below 105. To put today’s move into perspective, the drop in US stocks today was the most since the September 11 attacks in 2001. Unless stability returns to the financial markets, all of the Japanese Yen crosses including USD/JPY will continue to suffer.
WILL A FED RATE CUT BE ENOUGH OF A LIFELINE TO SAVE THE MARKET?
Since the beginning of the year, we have lost 3 of the largest investment banks on Wall Street and such unprecedented developments have called for unprecedented actions by US government and Wall Street officials. Since the announcement of Lehman Brothers (LEH) filing for bankruptcy and Bank of America (BAC) taking over Merrill Lynch (MER), AIG (AIG) has been given special permission by NY authorities to tap into $20bln of its own capital to prevent a liquidity crisis and credit downgrades. The Federal Reserve is also holding a special meeting to discuss possible remedies to AIG’s problems. The ECB and the Bank of England have pumped more liquidity into the financial system while the Federal Reserve made an unusual intervention to drive Fed funds lower.
Why Did Fed Funds Soar to 6 Percent when Futures are Pricing in a Rate Cut?
Fed fund futures are pricing in an 80 percent chance of a 25bp rate cut tomorrow by the Federal Reserve. This is a big change from last week, when the only thing that the market was thinking about was a rate hike. However despite this sharp shift in expectations, Fed funds surged to a high of 6 percent, 400bp above the Fed’s target rate of 2 percent intraday. This jump in the overnight lending rate between banks indicates that no one wants to take on risk.
Trust is a commodity these days as the move in Fed fund futures suggests that no one knows if their counterparty will be here to survive another day. Fund funds gave back all of its gains by the end of the US trading session, but that does not mean that risk appetite has returned – quite the contrary. AIG is in big trouble, Washington Mutual (WM) is still on our watch list with their bonds now cut to junk status by Moody’s, and the worries now turn to Goldman Sachs (GS) and Morgan Stanley (MS), who will be releasing earnings this week. Large write downs could drive a nail in the coffin for the US stock market and USD/JPY.
Of all the pairs in the currency major, USD/JPY and other carry trades will be hit the worst. Over the past 3 years, there has been a 68 percent correlation between the VIX and USD/JPY, so higher volatility means trouble for the currency pair. Although consolidation in the banking sector was something many people expected, no one thought that the consolidation would occur as a result of Chapter 11 filings.
Will a Fed Rate Cut be Enough to Shore Up Confidence and Trigger a Reversal in the US Dollar?
So far, the efforts of the US government have failed to bring any stability to the financial markets. Stocks dropped more than 500 points today, 2 year bond yields plunged a jaw dropping 40bp, while the repatriation has lifted the dollar against everything except for the low yielders until the last hour of trading. The market is now turning to the Federal Reserve for help, but a rate cut may not be enough to shore up confidence. In addition to balancing growth with inflation, the Federal Reserve is also responsible for maintaining stability in the banking sector and right now, they need to step up to the plate because judging from the price action in the markets today, expanding lending facilities and adding $70 billion of temporary reserves to the banking system is not enough.
With oil prices below $100 a barrel, the economy deteriorating, the financial markets in disarray and the Dow Jones Industrial Average down more than 15 percent year to date, there is no reason for the Federal Reserve not to cut interest rates. However, the more important question is whether or not a rate cut will be enough to put an end to the volatility. In our opinion, it is not enough. Even if the Fed cuts interest rates, that may not reduce the true cost of borrowing and relax terms of credit. Default risk is the market’s biggest problem and is the primary reason why reducing risk, dumping exposure and repatriation is the one cohesive theme that we are seeing across the financial markets.
What About SWFs?
This dynamic continues to drive the dollar higher despite the systemic risk and is the reason why its performance against the low yielders (yen and Swiss franc) is dramatically worse than its performance against the other majors. However, if the problems exacerbate and the Dow hits 10,000, Sovereign Wealth Funds may start dumping their US investments, which would turn the systemic risks from dollar positive to dollar negative. We began to see this at the end of the US trading session.
With the problems in the financial sector, no one cared about the weaker than expected Empire state manufacturing survey and industrial production report. In addition to the FOMC rate decision, consumer prices, the Treasury International Capital report and the NAHB housing market index are due for release on Tuesday.
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This article has 6 comments:
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who
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122 Comments
Sep 15 11:35 PMRate cuts are like stoking the fire is this what we need? Action taken by the Fed has limited positive impact so far - do we something a little more drastic? Watching HP conference yesterday was not reassuring as the market responded accordingly.
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karl49
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Sep 15 11:54 PM-
O-B-WON
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curious cat
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Sep 16 12:56 AMfear not, for i am with you- God
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Sep 16 10:42 AM