Now that the dust has settled a bit from the Fed’s 50 basis point increases in the Fed funds and discount rates last Tuesday, how did things shake out during the week in the aftermath of the Fed’s surprisingly aggressive action:

• Stock indexes posted a sharp rally, with the S&P 500 making a run at the July highs.
• The U.S. dollar weakened to new lows, with the U.S. Dollar Index barely staying above its all-time 78.19 low.
• Foreign currencies moved up sharply against the U.S. dollar almost all across the board with the Canadian dollar at 30-year highs and even reaching parity with the U.S. dollar.
• Gold prices rose to the highest level in 27 years.
• Crude oil prices hit new record highs.
• Soybean futures reached $10 a bushel and corn prices rallied.

A lot of the higher currency and commodity prices has been attributed to the sinking U.S. dollar and perceptions that it can only get worse. U.S. Treasury Secretary Henry Paulson proclaims that a strong U.S. dollar is in the best interest of the country but adds that “values should be set in a competitive marketplace based on underlying economic fundamentals.”

Doesn’t sound very hopeful for the dollar considering how the effects of the housing slump and credit debacle are weighing on U.S. economic growth. Nearly everyone seems to be painting a scenario of a weaker dollar equaling even higher commodity prices and higher inflation, but the big risk is a potential dollar-selling panic if its value drops much further. Even now there must be big money wondering why they should keep their funds in a dollar that’s losing value. Running the brinksmanship of panic is a little scarey.

One positive: Most people are thinking one way, and you know the market adage about having too many people on one side.

As for the stock market, remember then Fed Chairman Alan Greenspan’s New Year’s surprise in 2001? The Dow had slumped 15% from its peak, people were beginning to worry about a recession, and the Fed had held rates steady at 6.5% when the Fed decided the economy needed a little boost and chopped the Fed funds rate by 50 basis points.

Like last week, that cut was good for an initial shot in the arm for the stock market. Greenspan’s Fed continued to lower rates all the way to 1%, but, ominously, that didn’t keep the R word away. And you probably don’t need a reminder about what happened to the stock market in the two years after Greenspan started his interest rate decline.

Posted by at 11:08 PM | Permalink | Comments (0) | TrackBacks (0)

Well, the deed is done, and the markets are moving. Instead of muddling in the middle with a 25 basis point decrease in the Fed funds rate, the Fed apparently decided to go all out Tuesday with a 50 basis point cut to 4.75% in an attempt to forestall further economic weakness and a recession.

Everybody had pretty much accepted at least a 25 bp hike, so that wouldn’t have been very market moving. Stocks obviously loved the 50 bp news, sending the S&P 500 above the 1500 level again for the first time since the skid that started in July, and currencies such as the euro soared immediately after the announcement. It also seems to be good news for beleaguered home owners facing higher mortgages payments.

But was the larger decrease, the first 50 bp decrease in the Fed funds rate in nearly five years, a wise move? More bad news on the housing, construction, jobs, etc. front is almost certainly forthcoming, but the economy seems to be absorbing the early shocks from the sub-prime mortgage and hedge fund debacles and is, albeit more slowly, plodding along. Instead of waiting to see more data about how things are progressing after the mid-year slump, the Fed now has a little less flexibility to react at its next meeting Oct. 30-31 in case its larger cut doesn’t have the positive effect it wants (although it still has room to bring the discount rate down further).

The main casualty in all of this is likely to be the U.S. dollar, which has been teetering on the brink of sliding to new lows and is now almost certain to head for new lows. There is evidence from past episodes of declining Fed funds rates that the U.S. dollar could surprise everyone and gain strength, based on the assumption that the rate increase and its impact on the dollar was already in the market. But whether that will happen this time remains to be seen with the dollar at its current lowly position.

The prices of commodities such as oil and the metals jumped along with the foreign currencies after the announcement. Other markets such as grain and soybean futures had just ended their regular trading sessions for the day when the Fed released its statement, and it will be interesting to see how they respond. With presumably more pressure on the dollar, prices of all markets priced in dollars seem likely to head higher.

Higher prices brings up that “I” word again – inflation – that the Fed has been fighting for months. The Fed is always walking a fine line between inflation-recession, but how will it respond when that “I” monster becomes an issue again?

Posted by at 10:04 PM | Permalink | Comments (0) | TrackBacks (0)

Much is being made about what the Fed will announce Tuesday about short-term interest rates. Some would contend this may be the Fed’s most critical decision in years, at least during Fed Chairman Ben Bernanke’s tenure. Here seem to be the choices, in order of what analysts seem to think is most likely:

Reduce the Fed funds rate by 25 basis points – the markets appear to have that expectation built in after the decline in the job situation and the housing/credit/hedge fund turbulence of recent months. This modest first step, the first Fed rate reduction in more than four years, probably would not shake the U.S. dollar status too much, but would it be enough to stimulate the economy and head off a recession or a stock market setback?

Reduce the Fed funds rate by 50 basis points – this would be a sharp turnaround in the Fed’s fight against inflation but could deal a real blow to the dollar as the interest rate differential with currencies such as the euro would widen, would send funds flowing overseas and would reduce confidence worldwide in the dollar as a reserve currency. The U.S. Dollar Index (which is not the same as the value of the dollar but a good proxy for forex traders) is barely hanging above all-time lows just above 78, and if that level gives way, it could set up a collapse that feeds upon itself. And that has potentially ominous ramifications for a lot of commodity prices. Besides, can the Fed really prevent a recession or does it just tag along with actions after the fact?

Keep the Fed funds rate as it is – while that might be the most supportive choice for the dollar, the disappointment for the economy, some commodities and the stock market might set off an unwelcome chain of events. Stock indexes have moved up nicely after the July-August skid, but history shows it often takes only a spark to set off a contagion. And, at this point, a non-move would seem to be the surprise that could cause a setback and make this another September-October for financial traders to remember.

I’m not a Fed governor, thank goodness, and not much good at figuring out the effect of all these fundamental factors. I’ll see what happens on the charts, but my guess is the Fed won’t take any extreme actions, won’t please either side and will muddle in the middle with a 25-point increase, leaving the dollar and the economy to work out their own situations.

Going into the Fed meeting, the key point now is that, if it comes down to guessing about the outcome of some development or the other, it is not a good time for any trader to be over-committed. Be careful out there this week!

Posted by at 10:03 PM | Permalink | Comments (0) | TrackBacks (0)

Every time I hear or read that a market “has” to do something, I think about the consequences if it doesn’t behave as expected. The market doesn’t have to do anything, no matter what the fundamentals or technicals or historical intermarket relationships or logic or any other factors suggest.

This comes to mind again as the prevailing stream of thought seems to be that if gold prices are rising, the U.S. dollar should be declining – or vice versa. Gold is on the verge of breaking above its 2006 highs on one of its rare trips above $700 an ounce, and the dollar is on the edge of what may be a plunge to who knows where. Crude oil and some other commodity futures prices are making new highs, which some see as additional signs the dollar is doomed.

Well, maybe it isn’t. Admittedly, the Fed is in a tough spot but will it sacrifice the dollar by reducing the Fed funds rate – futures suggest by 50 basis points – next Tuesday in an effort to “save” the economy and the stock market after the miserable jobs and housing numbers lately? Assuming the Fed can make a difference in guiding the economic future to avoid a recession, what if it decides to maintain the status quo and leave interest rates where they are? What are the ramifications for gold and all those higher commodity prices that feed off the dollar?

Like the markets, the Fed doesn’t have to do anything. Odds are it will not be able to resist tinkering with the system. But what if it doesn’t?

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