Sub-Prime, the Fed and the Weak Dollar

By Clark Kendall



Financial markets got off to a weak start in the third quarter but finished strong in the final days of September. Large cap stocks faired better than small cap stocks - due in part to the weakening U.S. dollar which boosts profits of firms with overseas operations.

Growth once again outperformed value stocks, a trend we have seen throughout 2007 which is markedly different than the previous five years. The Standard & Poor's (S&P) 500 Index rose 1.56% for the quarter, ahead of the S&P Mid Cap 400 Index (-1.17%) and the S&P Small Cap 600 Index (-2.05%).

The following are the three main factors that affected financial markets in the quarter:

• Sub-prime goes sub-par

• The fed to the rescue

• The dollar weakens



Sub-Prime Goes Sub-Par

In a nutshell, many mortgage lenders offered loans to people who could not afford them. As long as housing prices rose, that was not a major problem, since homeowners could always sell their home or refinance their mortgage if times became difficult. When housing prices began to fall, however, things changed. Homeowners in distress could no longer sell their houses at a profit and many owed more to the bank than their homes were worth (a situation called "up side down").

This is not "new" news. The sub-prime mortgage problems were well known in February of this year. However, it became "big" news when the problems spread from companies that only dealt in the sub-prime market to companies that deal in the prime market (the prime market refers to borrowers with good payment histories and credit scores). In July, Countrywide Financial - the largest mortgage lender in the United States - slashed its 2007 earnings outlook due to the "increasingly challenging" housing and mortgage markets. The news startled Wall Street because Countrywide was thought to have limited exposure to the problems in the sub-prime market.

The subsequent days were marked by heavy selling on the major exchanges. The New York Stock Exchange registered its heaviest volume day in its history. U.S. home prices, as measured by the S&P/Case-Shiller Index, fell by 4.5% in July versus the year-ago period - the steepest drop in home prices in 16 years. Sales of existing homes, meanwhile, dropped to their slowest pace in five years. Financial markets fell and all eyes turned to the Federal Reserve.



The Fed to the Rescue

The Federal Reserve carries a significant burden in the U.S. financial system. It is charged with regulating short-term interest rates that affect things like credit cards, certificates of deposit and money market funds.

The Fed has to keep a tight lid on inflation and promote economic growth - goals that can often interfere with each other. The Fed can lower interest rates to spur economic growth - but that growth might cause inflation. The opposite is not much better. Raising interest rates may slow down inflation, but it comes at the cost of the economy.

For months now, the Federal Reserve has been content to stand aside and leave interest rates unchanged. While the Fed saw signs of economic weakness, it also saw signs of inflation and was thus unwilling to lower interest rates.

That changed when the "credit crisis" hit. When major financial institutions began reporting losses stemming from the sub-prime and housing markets, the Federal Reserve determined the risk to the economy outweighed the risk of inflation. Hence, the Federal Reserve lowered short-term interest rates. It began by first lowering the "discount rate" by 0.50% to 5.75% on Aug. 17, 2007 (the discount rate refers to the interest rate that the Fed charges banks directly). Then, on Sept. 18, the Federal Reserve cut the Federal Funds rate by 0.50% to 4.75%. (The Federal Funds rate is the interest rate that banks charge each other for short-term loans and has a larger impact on the economy than the discount rate.) The Fed also cut the discount rate on Sept. 18, sending it to 5.25%.

The cuts spurred buying in stocks, which were seen as the biggest beneficiaries. But what could be the downside to the Fed's actions?



The Dollar Weakens

The most salient issue coming out of the Fed's unexpected move is a weak U.S. dollar. The world's "reserve currency" - or the most widely used currency - has been weakening in recent months relative to other major currencies like the Euro and British pound. Today, one Canadian dollar equals one U.S. dollar while one Euro is equal to $1.41 U.S. dollars.

Cutting interest rates weakens currencies because investors seek out high yields on their investments. For example, a government that pays 10% interest on short-term investments is going to attract a flood of investors from the outside world, prompting strength in that country's currency. However if that government cut interest rates to 2%, fewer investors would be willing to loan their money to the government or banks in that country (assuming other world yields were higher than 2%). That weakens a nation's currency.

The weak U.S. dollar will have an impact on the U.S. economy in the future. First, consider the positive impacts: U.S. firms that sell their products overseas see increased sales when the dollar weakens. However, the risk of losing international investors who may migrate to investments in Euros or pounds is real. Over the long term, a weak dollar could limit the U.S. government's ability to borrow money at low interest rates.



Clark Kendall, CFA, CFP, is chief investment officer with Kendall Capital in Sandy Spring. He can be reached at 301-260-7935 and ckendall@kendallcapital.com.