The U.S. dollar is higher across the board but down sharply against the yen as risk appetite is sharply curtailed following the Fed’s decision to opt for the smaller option in both interest rates, cutting the fed funds rates by 25-basis points to 4.25% and the discount rate by only 25-bps to 4.75%.
Smaller cut boosts USD from yield and risk appetite perspective
The smaller easing option of 25-bps in both the fed funds and discount rates boosts the dollar from a yield and risk appetite perspective, sparing the dollar from a more aggressive cut in its yield foundation and triggering reduction in risk appetite, which is associated with broad yen gains and unwinding of dollar shorts against non-yen currencies.
Fed moves deeper into downside balance of risks
Consistent with the deterioration in credit markets and the Fed’s downgrade of its growth and inflation projections for 2008 and 2009, the Federal Open Market Committee (FOMC) has shifted back towards a neutral bias by indicating that: “Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time.”
Although the Fed kept its vigilance on inflation by stating, “…committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully,” we expect the market to continue pressing the Fed to deliver further easing ahead. Recall the dollar rose in the Oct. 31 decision to cut rates by 25-bps when the FOMC shifted towards a more balanced policy stance by stating, “The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.”
The fact that the Fed shifted from a dissent of one member wishing no rate cut in the last meeting to a dissent of one member (Rosengren) wanting a larger, 50-bp rate cut reflects:
the fresh urgency to cut rates further and
the dovish mindset in the central bank.
Yield Curve Says More Cuts Ahead
U.S. Treasury yields fall across the yield curve with further steepening of the yield curve (measured by the widening difference between 10- and two-year yields) reflecting aggressive pricing of further Fed rate cuts, which is weighing on the dollar. Consequently, the 10-/two-year yield spread has risen back to 106-bps from 80-bps before the announcement, suggesting further cuts ahead. The spread has now risen from 54 after the Sept. 18 announcement, 93-bps from the October decision and 100-bps from today’s decision.
Looking at the historical pattern between the 10-/two-year spread and Fed easing, we expect the 10-/two-year spread to rise by at least another 70-bps or 75-bps to about 180-bps, which will be equivalent to at least 75-bps of easing within the next six months. Looking at the last easing cycle, where credit conditions where almost as dire as they are now, the spread went to as high as 270-bps. This means that we could reach a time when two-year note dips to 2.00% and the 10-year bounces back to about 4.50% on fears of stagflation.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
a.laidi@cmcmarkets.com
