Asset Market Muddle Highlights Uncertainty On Economy

Stocks, bonds and the dollar just aren't seeing eye to eye these days.

Stocks are the most optimistic of the bunch, rallying sharply since the Federal Reserve's hefty 50-basis-point interest rate cut on Sept. 18, while the dollar has sunk to all-time lows versus the euro amid talk of further rate cuts and anemic growth. Treasury bond prices are stuck squarely in the middle, with the market looking for further economic weakness before it assumes much more policy easing ahead. Behind the divergence in the three markets is "a certain level of uncertainty regarding both the prospects for the economy...and what that means for Fed policy," said John Canavan, economist at Stone & McCarthy. While some expect continued weakness in the maimed housing sector to hurt jobs and spill over to the consumer - necessitating further rate cuts - others see the economy stabilizing and then gradually picking up steam, making further easing unnecessary. A recovery in U.S. growth combined with continued inflation pressures could even cause the Fed eventually to raise rates again, some say. The standout pessimist of the three asset classes has been the dollar. The greenback was already floating around all-time lows versus the euro before the Fed cut rates, but the easing unleashed a tidal wave of declines. The U.S. currency has notched up eight successive session lows versus the euro through Monday, when the single currency hit $1.4280. The ICE dollar index - which measures the greenback's value against a basket of six currencies - hit an all-time low this week, and the U.S. currency recently suffered the ignominy of falling to parity with the Canadian loonie for the first time in 30 years. The dollar's decline has been much deeper and swifter than analysts expected, with investors predicting that further Fed cuts will eat away at the currency's long-standing interest rate advantage. Higher domestic rates tend to boost a currency. Stock markets, on the other hand, have made sharp gains as investors' risk appetite has returned somewhat amid an easing of the summer-long strain in short-term debt markets. Monday, the Dow Jones Industrial Average hit closing and intraday records, with the major indexes each ending up by nearly 1.5%. The Nasdaq Composite Index hit its highest level in six and a half years. Treasurys are somewhere in the middle. In many ways, the bond market was ahead of the curve, pricing in multiple rate cuts early in 2007 in anticipation of an economic downturn. The market had a fresh rally as the credit crunch deepened over the summer, limiting the room for hefty gains when the Fed finally cut. While the two-year yield dipped back below the key 4% level after the Fed's decision in mid-September, longer-maturity Treasury prices have declined, sending 10- and 30-year yields higher. Interest rate futures market have also pared back their bets on further rate cuts in 2007. "Treasurys have come an awful long way," said Kevin Flanagan, executive director and fixed income strategist at Morgan Stanley Individual Investor Group. "We need further signs of weakening to improve from here."

Asset Classes Interact

None of that's to say that the three asset markets are circling in entirely different orbits. Fed rate cuts typically unleash a period of stock market buoyancy with investors cheered by the idea that the central bank is prepared to ease financial conditions to get growth going again. What's more, part of the divergence is explained by the fact that the action in one asset market is being noted and reacted to in another. For example, dollar weakness is boosting U.S. exporters and helps makes local stocks cheaper for foreigners - both factors that are supporting the broader stock markets. Equity market strength could help cushion the blow to the consumer from the stymied housing market, making Treasury investors less bearish on the outlook. Bond investors are also watching dollar declines since the currency's weakness has fueled inflation concerns and is one of the factors driving down long-term Treasury prices. The coming days could see the various asset classes line up more in step. The dollar reversed some of its recent losses Tuesday, with investors focusing on this week's employment reports and the prospect that they could reveal greater labor market strength than the August jobs reports. The September jobs report is expected to show payrolls expanding 100,000. If the reports suggest that August's first negative payrolls reading in four years was an anomaly, the dollar could be set for something of a bounce back, said Andrew Busch, global foreign exchange strategist at BMO Capital Markets in New York. "From here, I find it difficult for the greenback to sink much further this week given that the employment data on Friday should be good. Actually, we could see a decent rally" for the dollar, he said. Absent that, investors at least have the luxury of seeing a range of possible outlooks sketched out for them. Picking out which asset class has it right, and which is living in Cloud Cuckoo Land, will make the difference between making - and losing - a lot of money.