Dollar Hits Another Record Low, Does The Fed's Liquidity Injection Replace A 75bp Cut?

The dollar has just hit a record low against the euro and equities have extended Tuesday's record breaking rally. And, like the broader financial markets, activity in the credit and money markets have seen a sharp spike in volatility recently stoked by inflammatory economic data and exogenous event risk that was both threatening and promising. By the end of last week, credit conditions were taking a severe turn for the worse. Lending activity was already being constricted owing to the tighter borrowing requirements following record losses reported by Freddie Mac and Fannie Mae. This was only exacerbated after indicators reported the service sector was contracting and employment fell for the second consecutive month. With dual concerns of an impending recession and deepening credit crunch, the outlook was bleak. However, when conditions seemed to be at their worst, the Fed once again stepped in with an expanded effort to revive liquidity.

Do you think the Fed's next cut has been put off? Cast your vote in the DailyFX forum!

                                                                                           Improving outlook means the Federal Reserve could use this indicator to
                                                                                                    support a rate hike. The opposite stands for a deteriorating outlook.

For additional insight on what the Fed will do next, learn what pushed the Fed into Panic Mode. 

CREDIT MARKET: HOW IS IT DOING?

Like the broader financial markets, activity in the credit and money markets have seen a sharp spike in volatility recently stoked by inflammatory economic data and exogenous event risk that was both threatening and promising. By the end of late week, credit conditions were taking a severe turn for the worse. Lending activity was already being constricted owing to the tighter borrowing requirements following record losses reported by Freddie Mac and Fannie Mae. This was only exacerbated after indicators reported the service sector was contracting and employment fell for the second consecutive month. With dual concerns of an impending recession and deepening credit crunch, the outlook was bleak. However, when conditions seemed to be at their worst, the Fed once again stepped in with an expanded effort to revive liquidity.

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A DEEPER LOOK INTO THE CHANGES THIS WEEK:

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The sharp correction in the premium behind default risk a week ago has been quickly retraced over the past few days. By Friday, after the round of very disappointing economic data, the cost of insuring against default in swaps surged to 188 basis points – the highest level in history. It is still too early to tell whether the Fed’s auction plans will quiet fears of a debt market on the brink.

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Short-term money markets have taken the brunt of the credit market’s volatility blow. Demand for short-term debt has driven T-Bills and Libor rates to new mutli-year lows. Looking ahead, rates on the short-end of the yield curve will tell us whether the market is comforted by the Fed’s new TSFL program first. The acceptance of mortgage-backed securities for the loan and the additional $200 billion in liquidity looks promising. 

STOCK MARKET: HOW IS IT DOING?

The benchmark stock indices were gaining momentum into a bearish breakdown through the end of last week. Technically, the Dow’s break below 12,000 was the signal for equity traders to abandon the hope in a possible stabilization in selling pressure. Fundamentally, the rise in risk aversion was prompted by fears that the economy was already working on the first quarter of a recession – whether analysts had the government’s lagging GDP numbers to confirm it or not. The ISM’s service sector activity gauge raised the alarm by reporting its second monthly contraction – the first back-to-back decline since 2002. With its factory-based counterpart offering similar readings, it is hard to argue positive growth. Friday’s NFPs further roused growth fears with the biggest drop since 2003. With all this data, the Dow was in a free fall, looking to mark a new multi-year low. However, the Fed’s lending efforts once again thwarted a serious equity sell off. On the day the TSLF was announced, the Dow produced its biggest one-day rally since 2002.

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The news that the Fed was stepping up its efforts to remedy the worsening problems in lending and credit markets had a consistently positive impact across the various sectors of the equity market. Seeing one of the sharpest reversals was the real estate group. After the steady battering the housing market received after announcements of strict lending regulations and record foreclosures, the sector was likely oversold. The news that the Fed would try to thaw credit markets would have a direct influence on activity and in turn firms’ bottom lines.

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Shares of investment houses and banks have seen incredible volatility over the past week. Before the TSLF was announced, the Financial group was on the lam due not only to the disappointing data that threatened growth and therefore business, but also reports that major hedge funds were not meeting their loan payments and margin calls. The next concern would be that they would have to dump their assets and firms would be holding even cheaper investments. The Fed’s announcement has since revived hope, but not much.

U.S. CONSUMER: HOW ARE THEY DOING?

The American consumer has little reason to be optimistic or expect anytime soon. This past week’s data has caste a particularly harsh light upon the health of the economy and the direct connections the downturn will have a on each consumer’s financial position. For the economic outlook, the contraction in the service sector (the largest component of GDP and source of employment in the US by far) seemed to bring the economy one step closer to the recession economists and market commentators have warned about. However, this data was still a few steps away from the consumer’s doorstep. The employment report was not. Likely to be the source of a new multi-decade low in consumer sentiment, net employment contracted for a second consecutive month in February. Fewer jobs and cooling wage growth will be joining soaring inflation. 

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 Hope that a bottom in the housing market may be found sometime in the near future seemed to have been completely snuffed out last week. Mortgage applications continued to tumble from their highs as potential home owners find the Fed’s rate cuts have not been passed on to the consumer; and instead, tighter lending restrictions have made it more difficult to borrow. The outlook looked even more dire when the MBA reported record foreclosures and the greatest number of mortgage delinquencies through the fourth quarter. And, while the Fed’s new auction program may help lenders, it will not likely help borrowers and home owners for some time.

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Companies with a direct correlation to discretionary, consumer spending have struggled to find their footing even after the Fed’s announcement led a historical rally in stocks on Tuesday. A timid turn was noted among lenders and home builders as the announced $200 billion injection in liquidity from the central bank promised lower costs for firms – even if the effort wouldn’t necessarily revive demand and sales. Outside of these interest-rate sensitive firms though, the market-wide rebound has eluded the consumer-sector. With employment falling and growth contracting, the outlook for spending is not bright.

With economic turmoil heightening in the US, learn more about the major concerns of the Fed.