Ahead of the Fed: Oil and the Dollar

The Federal Reserve Board of Governers will meet this week to vote on the level of the all-important federal funds rate. The federal funds rate is the overnight rate at which banks can lend federal funds to one another. By law, depository institutions, such as banks, are required to maintain a certain level of reserves with the Fed. A bank's level of reserves will vary day by day as its customers deposit and withdraw money. When a particular bank falls short of the required reserves, for whatever reason, they'll have to borrow funds from another bank with excess money. The rate they borrow at is the federal funds rate.

The Fed's goal in setting the rate is to achieve consistent economic growth, while at the same time controlling inflation. On the growth side, the fed will consider US manufacturing, which recently has stagnated; consumer spending, which in June fell as oil and food prices have risen; continued weakness in credit facilities; and a deeper housing contraction.

On the inflation side it's all about energy and oil prices, which in the past few weeks have seen major price contractions, since reaching all time highs. The Consumer Price Index, which tracks the prices of goods in the US continues to be relatively high due in part to high energy and transportation costs.

It's a fine line that the Fed has to walk, sustaining growth while keeping inflation in check. Most analysts are expecting the fed to keep rates steady at 2.00%. The risks of inflation still are heavily outweighed by the sluggish economy. However, we can expect the Fed to increase their inflation rhetoric, as the CPI rose 1.1% in June, the biggest gain since September of 2005, and energy prices remain relatively high.

I expect that any increase in inflation language will cause the dollar to strengthen and oil to weaken. Remember that since oil is denominated in dollars, its price acts as a hedge against a weakening dollar and vice versa. So if the fed hints that they'll raise rates in the future, the dollar is likely to get a short term boost, and oil will go down. You can gain exposure to a strengthening dollar through the PowerShares DB U.S. Dollar Bullish Fund, UUP, and to oil through the US Oil Fund ETF, USO.

I currently have no positions in any of the funds mentioned in this article.

Housing Bottom and Home Builders

Sorry folks for the lull in writing. I was taking the NY bar exam this week.

So we are nearing the 1 year anniversary of the official start of the Credit Crunch. Big news this week as Merrill Lynch continued to write off and sell of subprime sludge. Are they out of the woods yet? Definitely not. If you've been reading this blog, you'll know what I'm talking about. We won't see an end to this Credit Crisis until we see a bottom in the housing market.

Speaking of the housing market, D.R. Horton and Pulte home continue building up inventory. According to the Phoenix Business Journal, D.R. Horton started 2132 homes in the Pheonix area during the first six months of the year, and Pulte started 1764! I think these builders are gambling that we've hit bottom.

And its a big gamble, but for the big builders there's no choice, they have to keep money flowing in however they can. If we're not at the bottom, these builders and all those who keep adding inventory may very well be in trouble. Remember, right now, there's almost a 1 year inventory of homes on the market, and there's arguably little sign that the number will improve any time soon.

I still have a short position in DHI, and I'm sticking to it.

Analysis of the Housing Bill

The Emergency Housing Bill has made it through Congress. Will this be what’s needed to turn the Real Estate Market? Here are some important points about the legislation:

The Housing Bill will further curtail the number of foreclosures by setting aside $300 billion to help troubled homeowners with existing exotic mortgages. Many commercial lenders already have been aggressively working with homeowners since the summer of 2007 to prevent foreclosures through the renegotiation of their mortgages. It’s estimated that since that time 1.7 million foreclosures have been avoided through these efforts. Was government intervention really needed, when the market participants were already doing this? Especially since signs of a bottom, at least in the West, were already forming.

The Bill increases the maximum cap on the national debt by $800 billion to $10.6 trillion. In addition, Treasury essentially has been given a blank check to bail out Fannie Mae and Freddie Mac if needed. What does all this mean in terms of the strength of the dollar? I think the dollar is going to weaken as a result. Ultimately, the US government/ taxpayers are going to eat whatever losses come out of the Real Estate Market from here on out.

I do think that the immediate impact on the financial markets will be large gains in the Dow on Monday. Especially where commercial banks are concerned. Builders such as DHI, HOV, PUL, etc... will probably go up as well.

Note: I currently have a short position in DHI and will likely continue despite this bill.

Banks and the Discount Window

The Discount Window is the Federal Reserve's emergency lending mechanism. It's a good thing it exists, especially during a credit crunch like we have today. If the Fed wasn't there to provide banks liquidity, we'd literally see the financial system fall apart.

Commercial banks have borrowed more than 16 billion dollars a day this past week, a record amount. Because of the collapse of Bear Stearns, the Fed has also allowed investment banks to borrow as well, however, this past week investment bank borrowing was nil. Keep in mind these are short term loans that need to be paid back, either through more borrowing or if the banks have made enough money by paying them off. (Note the current rate at the discount window is 2.25%)