Today’s Federal Reserve Bank decision to cut the Fed funds rate by 75 basis points to 2.25%, a smaller cut than anticipated, suggests the central bank will continue to rely on interest rate reductions to stimulate the economy and stabilize the undergoing credit crisis. Cutting the discount rates by 75 basis points to 2.5% maintains the differential between the Fed funds and discount rate at 25 bps, which is a reflection of the need to make the discount window attractive for authorized banks.
It would have been nearly unprecedented for the central bank to slash interest rates by as much as 100 bps in a day when the broad stock indexes were up more than 3.0% during the session. Today’s decision was a conscious effort by the Fed to preserve its ammunition heading into what will be a deepening recession and ongoing market challenges. In light of the events of the past seven days, the Fed has unofficially confirmed that it is operating in a state of emergency and a 1.00% interest rate is unavoidable by end of June. Markets are already pricing rates to fall by 50 bps to 1.75% by the end of the April meeting, which will leave ample ground for an additional 75 bps in rare cuts into end of June. With Fed funds at 1.00% in June, the U.S. economy would be geared for sub 1.00% rates into the rest of the year. Our forecast is for rates to reach 0.25% by year end.
After a short-lived dollar decline and yen rally, these flows are now reversing as risk appetite is fueled up by the rate cut, dragging yen and euro crosses. Nonetheless, the U.S. dollar interest rate disadvantage has now deteriorated to its worst level in six years against the euro and two years against the British pound, and to levels not seen against the higher yielding Aussie and Kiwi in more than a decade. Compared to the low yielding Swiss franc and Japanese yen, the U.S. dollar’s rate advantage is now at its lowest since 2002 and 2004 respectively.
With currency markets expecting further Fed easing, accompanied by more modest measures from the Bank of England and Bank of Canada, the dollar’s negative tone should persist, with exceptional snapbacks against the GBP and CAD.
Equities show a case of Déjà vu with another +400-point gain day in the Dow, reminding markets of the possibility for renewed losses in subsequent days especially Thursday’s triple witching hour day, which is characterized by extreme volatility. We warned this morning that of the “bear market” rally phenomenon in equities, which is characterized by fierce one-day rallies of as much as 3.00% that are often reversed in a matter of one or two days. This was common during the beginning of the 2001-2002 bear market as these rallies proved detrimental to short-term traders anticipating persistent declines. We saw this last Tuesday, when the Fed’s announcement of $200 billion in special liquidity facilities was partially reversed in the following day, leading to renewed gains in the JPY and EUR at the expense of AUD, GBP and CAD.
USD/JPY breaches 99 level and the 99.40 trendline, facing resistance at 99.90 at which point we’re likely to see some bargain hunters reemerge. Support stands at 98.60, followed by 98.20.
EUR/USD faces interim support at $1.5660, followed by $1.5620. Bargain hunters include foreign central banks seeking bids at the 1.56 figure. The current retreat may reduce intervention pressure, which will fuel further upside ahead for the pair into the 1.5680s.
GBP/USD loses a full cent to $2.0080, facing support at $2.0065. Today’s release of lofty inflation figures may have proved bullish for the currency but overall fundamentals are expected to prevail and drag the pair to as low as $2.002—key trendline support.
Ashraf LaidiChief FX StrategistCMC Markets USa.laidi@cmcmarkets.com
