With the usual return of liquidity and volatility after the US Labor Day holiday, speculation over the timing and severity of the Federal Reserve’s next monetary policy shift has moved back into the forefront. However, the market’s outlook for rate hikes certainly isn’t supporting a strong dollar in the near-term. Looking at Fed Fund futures, traders have priced in an impressive 95 percent probability of at least one quarter point hike through the coming year. In contrast, there is only a 15 percent chance that the central bank will act before the end of this year. The certainty behind unchanged rates for the rest of 2008 is surprising considering the significant, positive revision to 2Q GDP last week and the ongoing rally in the US dollar despite the as of yet unfavorable outlook. This suggests that the greenback’s rally is likely a ‘best-of-the-worst’ move for the currency market; but how long can it last without rate support?

The health of the broad credit market continues to deteriorate – even though news has yet to confirm the worst case scenario that has been clearly laid out by market commentators (a bail out of Freddie/Fannie or a major US bank going under). On Friday, the FDIC took over the reins of the 10th US bank, bringing the pace of failures up to the fastest its been in 14 years. There are promising efforts being made (MBIA insuring $184 billion in municipal bonds and Lehman finding foreign interest), but with credit card bond spreads at record highs, we may be looking at the next trigger for a crunch: the consumer.

A significant upside revision to the government’s second quarter GDP numbers made for quite the economic headline this past week. However, the details of this report show a very different picture than what the headline reading suggests. In fact, when exports were excluded, growth through June ran at a mere 0.2 percent (as opposed to 3.3 percent headline). With the global economy slowing and dollar appreciating, trade’s contribution looks to wane in the future. This leaves growth in consumers’ and businesses’ hands. With unemployment at a four-and-a-half year high and both service and factory activity contracting, the outlook certainly isn’t promising.

The health of the financial markets will be a key topic of discussion for Fed policy members at the next rate decision two weeks from now. Topping concerns will be the health of the crumbling banking sector which is struggling despite the central bank’s liquidity injections and their efforts to increase transparency. One of the key threats to calm markets and a rebound in lending is the possibility of a major bankruptcy. This past week, the failure of Integrity Bank marked the 10th American institution to falter. This has clearly raised the risk that one of the top institutions will eventually follow suit (Lehman seems to be a popular target); and at the very least, the Fed’s watch list will grow with a few more names. Another looming issue is the health of Freddie Mae and Fannie Mac. With a considerable amount of short-term debt maturing later this month, we may finally find some resolution on speculation of a bailout.  

Equities have shown a strong performance over the past week on a rebound that has embraced the GDP revision and waning fears of an impending rate hike. However, this advance has been quickly capped; and the hesitation reflects the realization that consumer spending and global demand will only worsen with time. On the other hand, the drop in crude and other key commodities has been met with less skepticism. After Hurricane Gustav missed US producers in the Gulf of Mexico, crude gapped down to five-month lows for an 8 percent drop.

Confirming the hesitancy in equity and other dollar-denominated markets, the market’s key risk indicators are showing a steady rise in risk aversion. This past week, the S&P VIX (a gauge of fear in the stock market) rose to a monthly high 22 percent. The demand for protective puts has also been turned higher – though volatility here is masking the general trend towards safe guarding positions. For the currency market, the carry trade highlights an aggressive unwinding of risky positions. With yields differentials contracting and volatility rising, there is little safety in the carry.