The US dollar fell and stocks declined for the fifth consecutive day after Fed Chairman Bernanke lamented the recovery and retained a dovish tone. The euro was strong on speculation Trichet will stress inflation risks on Thursday. We look at the warning signals in the bond market and the chance of a double dip.
Sentiment about the US economy continues to deteriorate and it is dragging down the dollar and stocks. The S&P 500 was higher with 1.5 hours remaining in the session but fell and then fell further after Bernanke delivered his remarks. Dollar bulls were hoping the Fed Chair to would dismiss economic weakness as transitory or that inflation was accelerating but Bernanke was cautious and said US growth so far this year is “somewhat slower than expected” and that inflation was a concern but doesn’t see much evidence it is becoming broad-based. Stock market participants were hoping Bernanke would leave the dollar open for QE3 but he gave no hints at further stimulus.
In a separate speech, Atlanta Fed President Lockhart (voter) said there is a high bar for QE3 even though he is “troubled” by the slowing recovery. In order for the Fed to buy more bonds (beyond re-investments) he said there will need to be a dramatic GDP reversal, more unemployment or the risk of deflation.
EUR/USD rose to the highest since May 5 as it pushes up against 1.47. Strong EZ economic data and speculation Trichet will signal rate hikes on Thursday were behind the move higher. The pound also had a strong day while AUD lagged on the dovish RBA.
The bond market continues to flash concerning signals. A three-year auction was very strong and 10-year yields fell back below 3% despite supply later this week. Two year yields fell to just 0.41%. The bond market is flashing signs of more than just a dovish Fed; there is a demand for safety. Indications are also that Treasury dealers are positioned for bond yields to rise. This trade has gone badly against them, which tells us: 1) They will have to unwind the trade 2) Something they didn’t anticipate is happening in the economy (Weakness? Disinflation?)
This is one of the five or so times that the US has looked like it could tip back into recession since the crisis ended. It has proven resilient but this time neither the Fed, nor the Federal government is in a position to provide support. Remember that the bond market moved far before the crisis and that the USD weakened for some time before it became clear that the problems far exceeded US borders.