At 14:15 CET, the FOMC announced a statement that the committee had agreed to lower the primary discount rate by 50bp to 5.75%, while maintaining the Fed funds target rate at 5.25%. Moreover, the central bank extended the discount window operation by up to 30 days thereby providing liquidity over a longer term than usual.
The FOMC issued a statement (see below) arguing that the reduction in the discount rate was implemented to mitigate downside risks to growth due to the recent deterioration in financial conditions and tighter credit conditions. Moreover, the committee judges that downside risk to growth has increased appreciably.
While not on the dot, this action is very near to what we thought would happen in the paper sent out earlier today, Research USA: How can the Fed avoid a credit run’?. In this report, we pointed to the Fed expanding the range of assets eligible as collateral for the discount window (see here). This paper provides some reasons as to why the Fed cut the discount rate and not the Fed funds rate today. We think that the Fed will expand the range of assets eligible as collateral for discount window lending, even though this was not clear from the statement.
The reason why it did not lower the Fed funds rate now reflects a desire to step up measures gradually, while keeping flexibility. Moreover, the FOMC remains reluctant to ease monetary policy as it is concerned about the moral hazard implications, ie, that rate cuts could reinforce the impression that the Fed will always comes to the rescue.
The Fed has kept the door open to keep policy rates unchanged if normality returns fast, while at the same time clearly changing its stance toward an easing bias. While this action makes it increasingly likely that the Fed will cut rates on the upcoming meeting at September 18, the fallout from this meeting will probably depend crucially on near-term development in credit, money and stock markets. If it turns out that today’s action is sufficient to normalise the situation in markets, it is not unlikely that the FOMC could choose to keep the Fed funds rate unchanged at the coming meeting. On the contrary if market conditions continue to deteriorate or do not improve sufficiently, the FOMC will probably have to lower interest rates.
The ECB: The cut in the Fed Discount window probably changes the outlook for the ECB. Firstly, major central banks rarely change policy rates in opposite directions, and secondly, the ECB may now be more worried that the credit problems are not isolated to the US. Therefore, the chances of a September hike have fallen, and probably the ECB will take a wait-and-see approach. If equity markets rally and risk recedes from markets over the coming weeks, the ECB may still choose to raise rates in September. But it now seems at least equally likely that the ECB will postpone any tightening to be sure that markets can handle the tightening.
The Bank of Japan: We maintain our view that the Bank of Japan is unlikely to hike rates on August 23 and a rate hike is most likely postponed until October but is dependent on some normalisation of financial markets. Should the Fed reduce the Fed funds rate, Bank of Japan will remain on hold.
Emerging markets: Most Emerging Markets currencies strengthened dramatically on the Fed discount cut. The Fed is clearly lending a helping hand to the markets and this helps ease the fears of a wider global liquidity squeeze. That said, it is also a confirmation of the seriousness of the situation and it is not a given that this is enough to change the negative sentiment in Emerging Markets. The strengthening of the Emerging Markets currencies in our view must mostly be seen as short-term opportunistic buying and one can certainly not say that this the beginning of a new EM rally. We will continue to be in a stage of de-leveraging globally and this could put pressure on the Emerging Markets again soon - we simply do not know at this stage.
Fixed income markets: We think the Fed cut could lead to a return in risk appetite in the short run and through this channel put some upward pressure on the short end of Euro yields as the flight to quality bid abates. Valuations have been stretched a lot lately with 2Y German yields at 3.94%, basically pricing out all ECB hikes. Even though it may be harder to hike in September, it may raise odds that it can hike later if things calm down again. The risk is of course that uncertainty comes back in the markets and the flight to quality bid returns. Given stretched valuation and potential for a return in risk appetite we think risk / reward favours positioning for higher yields in Euroland. With the uncertainty in markets, targets should not be set too far away however as volatility is likely to continue to be high.
Equity markets: Today’s Fed action is an obvious positive sign for the stock market. The move is a sign that Fed is ready for short term action if the current bank credit turmoil starts to have macroeconomic consequences. To keep the stock market happy Fed has to balance between a) giving in to the short term pressure of getting the US credit and money market back on its feet, and b) avoiding sending a signal that a rate cut is initiated to underpin an ailing US economy. Our short term conclusion is that the Fed move may be just the step needed to calm down the stock market, a factor needed before any thoughts about a market recovery should be discussed. Our view is, however, that global stocks at a 15-16 years low P/E (12 mth. forward ) level are good value, and that stocks at end-2007 will be quoted 5-10% higher than today