Thursday, September 20, 2007

Treasuries and the Dollar Down, Oil and Gold Up – All From a Cut in the Fed Funds Rate?

As anticipated the effect on long term interest rates, oil, gold, and the dollar has been a decrease in the value of Treasuries (increase in interest rate) and an increase in the price of oil and gold, adding up to a decline in the value of the dollar. No need to worry about it at this time, we will not know for weeks or even months to come whether or not this was the right action for the Fed. However, with the increase in the price of oil you can expect higher prices for food and gas within a few months. From Market Watch:

Treasurys were lower Thursday, pushing yields higher, as the dollar's drop against most major currencies and recently high oil prices kept alive investors' worries about inflation in the wake of the U.S. Federal Reserve's interest rate cuts on Tuesday.

The euro broke through the $1.40 level for the first time on Thursday into uncharted territory, and the trade-weighted dollar index fell to a new 15-year low.

The fact that Saudi Arabia's central bank held rates steady overnight, failing to respond to a Fed cut for the first time ever, was taken by some investors as a possible signal that it could be mulling the end of pegging its currency to the dollar. That in turn raised concern that the world's largest oil exporter would reduce investment of its massive foreign reserves in dollar-denominated assets such as Treasurys.

"Fears that the Saudis will abandon the dollar peg has pressured bonds lower overnight," said Tom diGaloma, head of Treasury trading at Jefferies & Co.

The two-year note was down 5/32 at 99 27/32 with a yield of 4.083%, up from 3.982%.
"The 10-year yield topped 4.60%, even as foreign investors are getting cold feet on the dollar," noted analysts at Action Economics.

The drop in longer-dated bonds indicates the market fears that lower interest rates will lead to inflation over the long term, which would erode the value of fixed-income assets. Bond prices and yields move inversely to one another.

The dollar has fallen significantly against most major currencies since the Fed made its larger-than-expected half-point cut in both its federal funds target as well as the discount rate on Tuesday.
(my emphasis) Lower rates erode the returns on dollar-denominated assets.

The Fed said its move was made to prevent the fallout from credit woes following the subprime mortgage meltdown from dragging down the broader economy.

But on Thursday, most investors were focused on gauging external risks rather than domestic ones.

The lack of Saudi interest rate action "raises questions about the loss of the ostensible peg. We tend to be rather more narrowly focused on the economic risks in the U.S. and so less sensitive to the dollar -- perhaps analytical myopia on our part," wrote David Ader, U.S. government bond strategist at RBS Greenwich Capital.

He noted that the weaker dollar does potentially inhibit the actions of central banks such as the European Central Bank and the Bank of Japan. Foreign banks hold massive foreign currency reserves that they need to invest. Moreover, he said, the mass of dollars held by oil producers is surely rising with oil prices recently rising to new highs.

"The latter does get invested eventually and the some strong correlation between oil prices, oil producers foreign exchange reserves," and capital inflow data, he said.

Crude-oil futures closed above $83 a barrel Thursday, sending the expiring benchmark contract further into uncharted territory.

The dollar's plunge sent gold futures sharply higher, with the lead-month contract at one point hitting a 27-year high of $746.30 an ounce.

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