More cuts and the dollar’s goose is cooked

More cuts and the dollar’s goose is cooked

By: Fat Prophets

The US Federal Reserve’s higher than expected 50 basis point rate cut recently instilled some confidence to stockmarkets worldwide. But while Bernanke’s monetary easing may have applied a little grease to a creaky credit system, the implications of the central bank’s actions are more far-reaching than just a bounce in shares.

The rate cut pushed the US dollar down and we believe it has more to fall. The question now really revolves around whether the Fed’s rate cut is enough to spark US economy growth – or less optimistically - prevent a recession. If not, further rate cuts will be likely and this will of course lead to deeper dollar misery.

These risks stem from the main culprit for the recent sag in the markets - the subprime housing sector. Housing still forms the biggest weakness in the US economy and we believe hold further economic pain.

The prospects certainly look bleak. Starts and permits are at the lowest level for over 20 years and building confidence is at an all time low. Existing home sales have also dropped for the 13th consecutive month and inventory of new housing stands at a staggering record 10 months worth of sales.

And to make matters worse, a disturbingly large amount of low rate introductory mortgages are scheduled to re-set at higher rates in the first six months of 2008. This is very likely to result in rising mortgage strain for US households.

Defaults on payments will drive further foreclosures and as these continue, no doubt there will be more pressure on house prices. Pricing trends are deteriorating and the emerging data is starting to look concerning - prices in ten key US cities show the steepest drop in sixteen years.

This correction in home prices will dismantle the wealth illusion that was created by the housing bubble over the last decade. And as the value of their largest asset shrinks, households will also face a drain on spending power as their ability to draw on housing equity diminishes.

Part of Bernanke’s rate cut was supposed to ease the mortgage burden of homeowners’ facing higher interest rates. It is difficult, however, to see how it will have any immediate effect. Mortgage rates are based on long-term bond yields and not on the overnight cash rate that the Fed controls.

So, as households face a mounting mortgage burden, it looks uncertain whether the Fed’s latest rate cut will be enough to prevent belts being tightened and thus a slowdown in consumer spending cannot be ruled out. The consumer sector makes up about 70 percent of US GDP - its importance should not be underestimated.

Certainly, the consumer confidence indicators are not promising. The Conference Board’s consumer confidence index dropped below 100 for the first time this year and is at its lowest point since November 2005.

So, while the Fed’s monetary policy response to appreciably riskier economic conditions may have provided some relief to stockmarkets, the US economy still faces deeper issues spawned by cheap housing credit. The risk to the consumer could now provide the impetus for even further Fed easing.

The rate cut may prove to be insufficient to provide the necessary medicine to an ailing consumer sector but the effect on the US dollar was near fatal. After the Fed made its announcement, the US dollar plummeted and has continued to fall. If more rate cuts are carried out, and we believe this is inevitable given the reasons outlined above, the US dollar will have little choice but to follow.

This has led to a depreciation of the US dollar relative to other paper currencies. However, those nations with currencies pegged to the dollar continue to face inflationary pressures as they have imported US monetary policy through the exchange rate peg.

So much so that China, with its yuan pegged to the dollar, is now attempting to implement price controls to curb inflation. There is also speculation that the Saudi Arabian riyal’s dollar peg could be broken to curtail further inflationary pressures.

And as global investors flee the dollar, other investments have become increasingly more attractive. So far, commodities in general have shown notable strength. Base metal prices continue to soar and gold, the ultimate competitor to the US dollar, reached a multi-decade high last week.

We have also begun to see prices of other commodities follow suit – most notable the recent rising trends in the price of agricultural products.

Wheat, corn and soybeans have all risen strongly on tightening demand supply dynamics. With global population growth, economic expansion and continual industrialization of emerging countries, food inflation looks set to continue.

So it is becoming increasingly evident that inflationary pressures are mounting and with the continuing devaluation of paper currencies, these trends are likely to persist. As we contemplate the possibility of further Fed rate cuts, the fact is, any more will send the dollar flying further south.

So, sell the dollar, sell bonds and buy commodities, gold and oil in particular.

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