Market expectations about interest rates
Two major contradictory expectations drive the market, On one hand, combined weakness in equities, poor economic data both in the U.S. and Europe and now talk about a possible war are boosting Treasuries. Treasuries are good protection for people who are afraid of all those things. U.S. Treasuries driving the yield on the most widely traded five-year note to a 44year low, as speculation the U.S. may attack Iraq drove some investors to the safety of government debt. One the other hand, if we check what’s going on the futures market, the market expectation are that the fed will cut it’s rates. And if rates are expected to be cut, it’s pretty contradictory to buy treseuries now. Our major indicator of market expectations is the Fed Funds futures rates, and not surprisingly, the CBOT September Fed funds futures contract is priced to imply significant probability of an easing move at the September 24 FOMC meeting. The implied probability of a 25-basis-point rate cut ran as high as 90% in mid-August, and with Sep futures priced near 98.275 at month’s end, it remains around 50%.
Currency
Euro: Thanks to the problems in the U.S. economy and the determination of the U.S. government to eradicate terrorists without any help from Europe, the euro has been stronger. The real challenge for the Euro zone has always been to prove that they can sustain significant economic growth on their own, but they have not yet done that. The GDP was up 1.5% in 2001 and was up .3% in each of the first two quarters of 2002. The European Union is forecasting .45% growth in each of the third and fourth quarters. Unemployment remains high, at 8.3% in July. The consumer price index was up 1.9% in July from a year ago, which is below their target level. The European Central Bank last cut its main interest rate on November 8, 2001, from 3.75% to 3.25%. It was the fourth cut of 2001.
Because of disclosures in U.S. equity markets, the dollar has slid about 7% against the currencies of major trading partners since April. Some analysts fear that international investors will become increasingly reluctant to hold additional dollar-denominated assets in their portfolios. In that case, U.S. interest rates would rise, and the dollar would depreciate in foreign exchange markets. And, the accounting scandals driving down the U.S. equity markets cannot but make international investors more skittish about holding U.S. securities, making us believe along with poor US economic performances to see the dollar depreciating on foreign market. Our expectation seems to be the same as the market, if we check what’s going on the futures market, their expectation is to see the euro enforced, indicating that the dollar is believed to loose power against the euro. (see graph no ) However these expectations are for the short term. Past experience indicates that the American economy goes out from recession in period ranging from 6 mth to nine mth. Furthermore, as the new legislations in corporate scandals begin to work and consumer confidence rise, and low interest rates boost firms fund raising, we expect the dollar to regain power in beginning of the first quarter 2003 if non major event happens, like a war in Iraq.