Fed Can't Win In Weighing Subprime Risks

The more the US Federal Reserve acknowledges the credit-related problems, the bigger the crisis could seem.

The dollar is already in the spotlight as frayed nerves over risk and disappointing labor market data have pushed it lower. Now there's a substantial risk that the Federal Open Market Committee statement due later Tuesday could make matters worse. A rate cut Tuesday is viewed as highly unlikely. But, the market is hungry for detail on how the seemingly endless stream of bad news stemming from the subprime mortgage sector might trickle through to the Fed's thinking. And whatever the Fed says, it could add fuel to the dollar's drop. "The Fed is in a 'no win' situation," said David Simmonds, head of currency strategy at Royal Bank of Scotland in London. "The more they acknowledge the credit-related problems, the bigger the crisis could seem, but to say absolutely nothing risks leaving them looking blinkered," he said. "Striking the appropriate balance will be key. In these situations (former Fed Chairman Alan) Greenspan was masterful. (Current Chairman Ben) Bernanke is untested." Even if Bernanke manages to administer a hefty dose of soothing medicine to the market's painful ulcers, it's unclear what he can really achieve without a run of more supportive U.S. data. Last Friday's non-farm payrolls data came in around 40,000 below expectations at 92,000, sparking a hefty drop in the buck across the board. That's likely to haunt currency traders for some time yet. "The weaker-than-expected labor market report will remind investors that the key pillar of strength in the U.S. economy is now showing signs of weakening," said Hans Redeker, chief currency strategist at BNP Paribas. Redeker reckons a more accommodative tone from the Fed is what dollar bulls need. "The market will want to hear less hawkish rhetoric from policymakers," he said. "If this isn't delivered, it is likely that we will see further selling pressure for the dollar as the market analyses the Fed as falling behind the curve, failing to halt a financial problem, and probably even inducing a harsher economic slowdown," Redeker said.

Inflation Remains Predominant Concern

The subprime and credit market shakeout has been ugly for some heavily exposed banks and hedge funds. But, the jury's still out on whether the unwind is really infecting other regions and other asset classes. Analysts at Barclays Capital reckon the Fed might even hint that the market movements are welcome. "(The central banking community) may see recent events as a positive development - a reduction in overpricing in an important market with limited contagion," they said. "As such, we look for only modest changes to the FOMC's statement, which we think will only allude to recent market volatility as a source of uncertainty, while still indicating that inflation remains the predominant policy concern," analysts at Barclays Capital added. Stephen Jen, head of currency strategy at Morgan Stanley, agrees that the Fed is "not ready to alter its bias yet". For one thing, high oil prices and tight labor market conditions mean that the Fed is right to keep watching inflation. And aside from that, Jen says the credit market problems are still a "healthy risk-repricing process". "Moving to neutral now, without concrete evidence that financial developments are starting to have implications for the real economy, would convey the wrong message to investors and could sow the seeds for future moral hazard problems," Jen said. Either way, one thing's for certain: the dollar won't climb if investors get even more wary on risk. Over recent weeks, that's exactly what it has done, as traders use it as a safe-haven currency amid an apparently global risk storm. But, the dollar-positive flow as investors bring their overseas funds home, can only last so long, and it certainly appears to be over now. The trade-weighted dollar index slipped below 80 in early trading Monday for the first time since 1992. Early Tuesday, concern that the Fed may turn more dovish continued to undermine the dollar, which fell to Y118.81 by 0645 GMT, from Y118.94 late Monday in New York. The euro was up at $1.3799 from $1.3793, but fell to Y163.96 from Y164.05 as a continued rise in oil prices and the latest concerns over the global economy appeared to prompt some unwinding of carry trades.