Dollar Index And The Financial Sector

Dollar Index: Does Friday's decline in the dollar index indicate that midnight has struck and the dollars' Cinderella story is over? That will be the question on most traders' minds over the weekend after the euro and pound made huge one day advances on the greenback. The only thing that saved the index from a further decline was the dollar's advance against the yen, which came as the S&P gained 0.21% on the day. It seems that dollar bulls are going to have to contend with difficulties in the financial markets a bit longer in addition to the possibility of traders in Fed Funds Futures pricing in a rate cut at the October and/or December meetings.

As usual, the fate of the dollar rests in the hands of the Fed, who are making their rate decision on September 16 at 14:15 EDT. While no one expects the Fed to do anything other than hold on Tuesday, particular attention will be being paid to the accompanying statement. The Fed seemed to be taking a balanced approach at the last meeting by saying that, "although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee." Richard Fisher voted to increase overnight borrowing costs. The market priced any possibility of a rate cut out of Fed Funds Futures, and most investors seemed to believe the Fed's next move would be to the upside. That certainly played a large part in the dollar's appreciation.

Things look a bit different this time around. Energy costs have continued to decline, oil is near $100 per barrel and traders still seem to be trading the "demand destruction" theory. Certainly, conditions in the financial markets have deteriorated. Employment continues to weaken; the unemployment rate is already above where the Fed projected it would go by the fourth quarter. The number of people continuing to claim benefits is the highest in 5 years and this is beginning to effect retail sales, which declined 0.3% in August. Notably, the expected rate of inflation as measured by the spread between 10 year nominals and 10 year TIPS is just 1.95%.

Considering all this, traders may continue to sell the dollar on speculation that the Fed will change the bias from balanced to growth, and certainly if that were to occur it would be hard to imagine that the dollar would not weaken further. Let us also not forget how valuable a weak dollar is in terms of exports because as seen in the GDP report for the second quarter, the U.S. economy would have contracted 0.2% without the contribution made from this sector. On Friday, the dollar index fell 120 basis points (1.5%) to 78.95.

The Financial Sector: Washington Mutual (WM), the nation's largest savings and loan, had its debt ratings cut on Thursday. Fitch, citing a lack of "flexibility" to raise capital, cut its rating on the bank's debt to BBB- from BBB, while Moody's cut its long-term deposit and issuer ratings to Baa3 from Baa2 because of "reduced financial flexibility, deteriorating asset quality and expected franchise erosion." Moody's also reduced the senior unsecured rating to junk status (Ba2).

The bank is heading to its fourth straight quarterly loss and is facing as much as $19 billion in loses tied to residential mortgages. The drop on its credit ratings could force WaMu to sell part of its $143 billion deposit base, which would mean selling branches. WaMu said late yesterday it would set aside $4.5 billion to cover bad loans in the third quarter, a decrease over the preceding 3 month period, and that it "continues to be confident that it has sufficient liquidity and capital to support its operations while it returns to profitability." Goldman analyst Brian Foran upgraded the stock to "neutral" from "sell" on Friday saying the decrease in the reserves is "a glimmer of a silver lining."

"Toxic" might be the best descriptor for the Financial Sector. It would seem there just is no reason to invest while so much uncertainty exists. AIG (-27%), FRE (-23%), LEH (-15%), FNM (-9.6%) and MER (-9.2%) were the biggest percentage losers on Friday. WM (+4.24%) was an unlikely bright spot after the company issued statements saying its capital position was adequate, allaying market fears that it might be the next big bank to go down.

On the day, the XLF fell 0.30 points (-1.40%) to close on 21.15. Volume was moderately heavy; 254,999,481 ETF's changed hands against a daily average of 204,516,000.

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