Will the US Dollar Double Dip?

March 13, 2008

For the first time in over a decade, one US dollar bought less than 100 Japanese Yen. USD/JPY dropped to a low of 99.77 in the early European trading session as news of Carlyle Group’s potential failure broke. The hedge fund has had trouble meeting its margin calls last week and now, it faces outright liquidation. This sent shock waves across the markets, triggering a sharp drop in stocks, bond yields and the US dollar. The biggest fear right now is the possibility that the Federal Reserve is losing control. Each new step that they take has been nothing more than a band-aid for a growing problem.

carlyle If Carlyle Group defaulted, lenders will want to recover their funds immediately, forcing a liquidation of any open positions in the market. This would lead to another wave of volatility in the bond, stock and currency markets.

At this point, the Federal Reserve has no choice but to cut interest rates by 75bp. Fed fund futures are back to pricing in a 94 percent chance of a 75bp rate cut, up from a 64 percent on Thursday.

However, if they really want to do the right thing and put an end to the pessimism and risk aversion across the financial markets, they need to give the markets a surprise by cutting interest rates 100bp in one shot. Retail sales last month was very weak. The rise in food and gasoline prices have been too much for most consumers to handle and as a result, they have cut spending to the point where the decrease in demand has offset higher prices, making overall gasoline sales negative in the month of February. Interestingly enough, the US dollar did not fall on the retail sales report.

There were a bunch of rumors floating in the markets about why the US dollar and stock market recovered intraday, but I do not believe that any of these reasons are compelling enough to prevent a double dip in the US dollar. The Associated Press reported that the Senate has extended some of President Bush’s tax cuts, but this is limited. Standard and Poors indicated that the worst may be over for large write downs, but their main focus was on the severity of the subprime problems while rumors circulated about a number of different parties including the Fed, providing capital to Washington Mutual, the struggling mortgage lender.

The US government is getting desperate too. The House Financial Services Committee announced a Mortgage and Housing Rescue plan that would “permit FHA to provide up to $300 billion in new guarantees to help refinance at-risk borrowers into viable mortgages.”

There are many reasons to remain bearish US dollars.

Even though tomorrow’s consumer price report could be hot, that will not prevent the Federal Reserve from cutting interest rates by at least another 150 to 200bp. Therefore even if the dollar is rebounding off its lows today, we expect it to double dip back below 100 against the Japanese Yen.