Weekly Markets Commentary – April 28, 2008

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Focus on the Fed

For the past several weeks, investors have been focused on first-quarter earnings, particularly those of the major banking institutions, while looking for signs that the economy is set to improve.

Few are suggesting that the credit crisis has run its course, but the movement in an array of asset prices indicates that sentiment has been turning more positive. Bond yields have risen, particularly at the short end of the curve, along with stock and commodity prices, even as the dollar has firmed.

This week, the focus will be fixed intently upon the Federal Reserve and the economy. With the two-year note yield now well above the fed funds rate, expectations of further, aggressive easing by the Fed have been scaled back.

Two weeks ago, futures trading indicated an almost even chance of a half-point rate cut. Now, there is less than universal agreement that the Fed will cut at all.

And, where there was the expectation that the overnight rate would be cut to a low of 1.5 percent by August, the expected terminal rate for this cycle is now two percent.

The Week Ahead

Of course, what the Fed does will be determined in large part by what the data says. And, this week's economic calendar is full of potentially market-moving reports. Two are lagging indicators, but influential nevertheless.

The advance estimate of the economy's growth rate in the first quarter is scheduled to be released on Wednesday. While the consensus expectation of 0.5 percent annualized growth would be nothing to cheer about, it would be positive, contradicting the fever pitch of recessionary commentary.

Employment

A more ominous expectation surrounds Friday's release of the April employment report, where 75,000 non-farm jobs are thought to have been lost. The unemployment rate is expected to rise to 5.2 percent.

Inflation

On Thursday, the March personal consumption expenditures (PCE) deflator will provide a view of current inflationary pressure.

Keep in mind that there were two dissenting votes at the last meeting of the Federal Open Market Committee. The Fed is well aware of the potential for inflationary pressures to build while monetary policy is focused on growth and liquidity concerns. While the PCE report is expected to be benign, a worse outcome could have significant influence on future deliberations, not to mention the near-term path of both bond yields and the dollar.

Other important scheduled reports include the S&P/Case-Shiller Home Price Index for February, both the Chicago and national Institute of Supply Management reports on manufacturing, March personal income and spending, factory orders, construction spending, and April vehicle sales.

International Investing

For the past few years, investing overseas has been a profitable undertaking, in part because the dollar has fallen sharply. Using the DXY dollar index, from its peak in July 2001 through last Wednesday, the dollar fell 41 percent in value.

During that same time frame, the euro climbed from .8364 to the dollar to 1.5992, or 91 percent. For dollar-based investors, during that same interval, the MSCI EAFE index rose 75 percent in price only terms, while in local currencies the gain was a meager nine percent.

The point is that the trajectory of the dollar can have a profound impact on the overseas investing experience. With expectations rising that the Fed may be getting closer to the end of its easing cycle, there is the possibility that the dollar may find some near-term support, or even enjoy some appreciation. This would be especially true if foreign central banks, most notably the European Central Bank, pursue an easier monetary policy going forward.

Last Wednesday, the dollar hit a low against the euro of 1.5992 before ending the week at 1.5630. It has been climbing against the yen since mid-March. Dollar-based investors need to be aware that the conditions which contributed to dollar weakness may be changing.

Coupled with our view that the dollar is significantly undervalued relative to the major European currencies, now might be an opportune time to revisit unhedged, international asset overweightings.