Federal Reserve: Extended Period

The dollar rose about 1% late last week, the most sizable move to the upside in a month, after hitting the lowest level in a year on Wednesday.  The rise in the dollar was accompanied by a move toward high quality investments driving declines in stocks and commodities. However, this  bounce is likely to be short-lived with the dollar returning to the downward trend for an extended period.

The bounce in the dollar was prompted by Thursday’s existing home sales report that revealed a surprise 2% decline after four consecutive months of  gains. With U.S. overnight lending rates the lowest in the world in 2009, the United States has replaced Japan as the nation funding the so-called “carry  trade”. As markets rally, investors around the world borrow at very low rates in the United States and then sell those dollars to buy foreign denominated  investments; as markets pull back, those borrowers sell their investments and buy dollars to repay the loans. This carry trade has resulted in an inverse  relationship between the dollar and the stock market. The weaker than expected report on home sales prompted some investors to trim their bets  on the global economic recovery, resulting in a gain for the dollar and a decline in stocks and commodities.

Lowest Level

The dollar hit the lowest level of the year on Wednesday; the same day, the Federal Reserve released a statement from their meeting that continued to  include the phrase “extended period” as it relates to how long they intend to keep rates this low. This phrase appears in the last paragraph of the  statement: “The committee will maintain the…range for the federal funds rate…for an extended period.” The conditions that have helped to heal the  credit markets and improve the outlook for earnings remain intact and are likely to continue to support the stock market, while dollar deposit rates are  likely to stay low in the United States for an extended period, continuing the downward pressure on the dollar.

The last time the Fed used a phrase similar to “extended period” was from August 12, 2003 to January 28, 2004. This period saw the rebound in the  markets from the recession that followed the burst of the Tech bubble in the early 2000s. Then, the Fed used the phrase “considerable period” to indicate that they intended to keep rates low for some time. During that period of  time stocks rallied and the dollar fell. Currently, those same performance trends are in place and have been since the Fed began to use the phrase  “extended period” to describe their outlook on rates on March 18, 2009.

“Considerable Period” Removed

The Fed removed the phrase “considerable period” from their statements about fi ve months before the first rate hike in the middle of 2004. Once the  phrase was removed, signaling coming rate hikes, stock market performance stalled and the dollar reversed trend and steadily moved higher. We expect  the Fed to begin to hike rates in the middle of 2010. As a result, we expect that the Fed may not remove the “extended period” phrase as a signal of  coming rate hikes until sometime during the fi rst quarter of 2010, leaving the current trend of a rising stock market and falling dollar intact at least through  year-end.

An orderly decline in the dollar is not necessarily a bad thing. In fact, the dollar has declined steadily for most of the past 40 years. While we are  expecting an orderly decline in the dollar, a big drop would be unwelcome; it would raise the risk of a spike in interest rates, as foreign financing for  our budget deficit would be called into question. So far, the declining dollar has not destabilized the credit or equity markets, and that is a bet the Fed
is clearly still willing to make by indicating it does not intend to raise rates anytime soon.

A number of our investment themes are tied to the global recovery and a falling dollar, most notably our recommended positions in emerging market  stocks and commodities. We expect the environment to remain favorable for these recommendations for an “extended period”.

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity.
• Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
• Small-cap stocks may be subject to higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments.
• Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

photo credit: Steve Rhodes