Don't look for the dollar to fall in tandem with stocks if the Federal Reserve's response Tuesday to the recent U.S. credit crunch is simply to remind investors, "We told you so."
The Federal Open Market Committee will issue its customary statement Tuesday afternoon after its policy meeting, and it is likely to say there is no need to panic over the situation in U.S. credit markets. The Fed might also point out that for many months it has been telling deaf ears that risk was being mispriced.
This could cause a brief sell-off in U.S. equities as investors realize the Fed won't play the role of market savior. But the dollar, which had recently begun to tick lower when U.S. equities fall, is likely to hold steady this time.
That's because a "don't panic" response by the Fed would also be seen as hawkish on inflation, as it would support the Fed's prior suggestions that it is more likely to raise interest rates to stem inflation than to cut them to spark growth. This would support the argument that long-term growth prospects remain solid.
Still, the dollar's recent sensitivity to equity shakeouts suggests that solid dollar strength is also unlikely, even if the Fed does talk tough.
"If the Fed underplays the credit thing and suggests it doesn't think it's a big deal, look for the dollar to be neutral," said David Woo, head of global foreign exchange strategy at Barclays Capital in London.
But that doesn't mean the dollar has no reason to fear the Fed meeting. Equity bulls would love to see the Fed say it will consider easing interest rates to provide market liquidity and rescue the credit meltdown. Such a statement would surely boost stocks, but it might be brutal for the dollar, as interest rates still rule the roost in currency markets.
Dollar Stepping On Toes In Dance With Equities
Since the Dow Jones Industrial Average began to slide in late July, currency analysts have been keen to figure out how the dollar would act against its rivals in response to the ebbs and flows in equities.
For a while, it seemed equity weakness meant dollar strength. Throughout the final two weeks in July, the dollar's knee-jerk response to sharp declines in the DJIA was to rise against its rivals.
One camp said this was due to the dollar's perceived safe-haven status - investors sold their riskier bets in stocks and emerging market assets and transferred their funds into U.S. Treasurys or other dollar-denominated assets.
Others said the dollar's gains on equity declines were related more to the carry trade, in which investors borrow yen at low interest rates to buy currencies such as the euro or sterling, which pay higher interest rates. Woo said investors quickly dumped their long positions in the euro or sterling against the low-yielding yen.
Despite disagreements over what seemed to cause dollar's strength in the face of equity weakness, the debate was rendered moot Friday when U.S. equities tanked and the dollar plunged right along with them.
"The safe-haven related bid on the dollar over the last one to two weeks was punctured on Friday," said Divyang Shah, chief strategist at Commonwealth Bank in London. "The purging of risky (foreign exchange) positions has come to an end."
Don't Count On Mantras
Even amid the recent market turmoil, currency markets remain keenly aware of interest rate differentials between one currency and another. So if the Fed rejects the notion of near-term rate cuts, it would be hard to see the dollar suffer from this, even if equities fall, because no rate cuts would support the dollar's rate advantage over the euro and the yen.
But is it possible the Fed will start leaning toward rate cuts?
"If market conditions and a further decline in economic confidence reached the point that the FOMC had to ease late this year as money markets are now pricing in, the FOMC could move directly from a tightening bias to an ease, having done so in the (former Fed Chairman Alan) Greenspan era," said Greg Anderson, director of foreign exchange strategy at ABN Amro in Chicago. "However, ideally the FOMC would probably turn the ship slowly."
Anderson said it's more likely the Fed will simply express more concern about growth and less concern about inflation, but otherwise leave its statement relatively unchanged from its previous one.
Currency analysts at Brown Brothers Harriman said "the Fed does not appear prepared yet to signal 'all clear' on the inflation-front and will be likely to continue to see the risk that prices do not moderate as the predominant concern."
The Federal Open Market Committee will issue its customary statement Tuesday afternoon after its policy meeting, and it is likely to say there is no need to panic over the situation in U.S. credit markets. The Fed might also point out that for many months it has been telling deaf ears that risk was being mispriced.
This could cause a brief sell-off in U.S. equities as investors realize the Fed won't play the role of market savior. But the dollar, which had recently begun to tick lower when U.S. equities fall, is likely to hold steady this time.
That's because a "don't panic" response by the Fed would also be seen as hawkish on inflation, as it would support the Fed's prior suggestions that it is more likely to raise interest rates to stem inflation than to cut them to spark growth. This would support the argument that long-term growth prospects remain solid.
Still, the dollar's recent sensitivity to equity shakeouts suggests that solid dollar strength is also unlikely, even if the Fed does talk tough.
"If the Fed underplays the credit thing and suggests it doesn't think it's a big deal, look for the dollar to be neutral," said David Woo, head of global foreign exchange strategy at Barclays Capital in London.
But that doesn't mean the dollar has no reason to fear the Fed meeting. Equity bulls would love to see the Fed say it will consider easing interest rates to provide market liquidity and rescue the credit meltdown. Such a statement would surely boost stocks, but it might be brutal for the dollar, as interest rates still rule the roost in currency markets.
Dollar Stepping On Toes In Dance With Equities
Since the Dow Jones Industrial Average began to slide in late July, currency analysts have been keen to figure out how the dollar would act against its rivals in response to the ebbs and flows in equities.
For a while, it seemed equity weakness meant dollar strength. Throughout the final two weeks in July, the dollar's knee-jerk response to sharp declines in the DJIA was to rise against its rivals.
One camp said this was due to the dollar's perceived safe-haven status - investors sold their riskier bets in stocks and emerging market assets and transferred their funds into U.S. Treasurys or other dollar-denominated assets.
Others said the dollar's gains on equity declines were related more to the carry trade, in which investors borrow yen at low interest rates to buy currencies such as the euro or sterling, which pay higher interest rates. Woo said investors quickly dumped their long positions in the euro or sterling against the low-yielding yen.
Despite disagreements over what seemed to cause dollar's strength in the face of equity weakness, the debate was rendered moot Friday when U.S. equities tanked and the dollar plunged right along with them.
"The safe-haven related bid on the dollar over the last one to two weeks was punctured on Friday," said Divyang Shah, chief strategist at Commonwealth Bank in London. "The purging of risky (foreign exchange) positions has come to an end."
Don't Count On Mantras
Even amid the recent market turmoil, currency markets remain keenly aware of interest rate differentials between one currency and another. So if the Fed rejects the notion of near-term rate cuts, it would be hard to see the dollar suffer from this, even if equities fall, because no rate cuts would support the dollar's rate advantage over the euro and the yen.
But is it possible the Fed will start leaning toward rate cuts?
"If market conditions and a further decline in economic confidence reached the point that the FOMC had to ease late this year as money markets are now pricing in, the FOMC could move directly from a tightening bias to an ease, having done so in the (former Fed Chairman Alan) Greenspan era," said Greg Anderson, director of foreign exchange strategy at ABN Amro in Chicago. "However, ideally the FOMC would probably turn the ship slowly."
Anderson said it's more likely the Fed will simply express more concern about growth and less concern about inflation, but otherwise leave its statement relatively unchanged from its previous one.
Currency analysts at Brown Brothers Harriman said "the Fed does not appear prepared yet to signal 'all clear' on the inflation-front and will be likely to continue to see the risk that prices do not moderate as the predominant concern."
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