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Currencies and Cotton Candy Rate Cuts

Tue, Oct 14 2008, 14:53 GMT
by Jack Crooks

Money and Markets

I understand that the lending system is in bad shape. Or more specifically, that it's barely functioning at all. We're well past the point when central banks and governments around the globe inexplicitly declared it their duty to save their economies. But they really unleashed their helping hands this week.

That's especially true of the coordinated rate cuts from many of the world's Central Banks — everyone from the U.S. and Europe to China.

These moves have serious implications for all financial markets, but especially the currency markets. And today I want to tell you what I think is coming next.

Governments Make Bold Moves; Markets Shrug ...

Stocks started the week with a horrendous Monday that basically stated, "Bailout package? So what?"

Monday was followed by an equally bad Tuesday.

So the Federal Reserve, and every other central bank you may have ever heard of, did what many had been hoping they would do. They cut their benchmark interest rates.

But the markets continued falling. In short, Wednesday simply deflated any hopes of recovery to which a very small minority might have still been clinging.

Throughout recent weeks, Chairman Bernanke has guided billions of dollars of credit into money markets, supported the Treasury's $700-billion bailout plan, and taken steps to make accessing loans easier.

But until Wednesday, the Fed hadn't caved in to the newest pressures rocking the markets with official interest rate cuts. And surely to their disappointment, it's done little to better the current investment environment.

I Didn't Think the Federal Reserve Needed to Cut; Here's Why ...

Even though the Fed Funds target had been stable at around 2%, the market-determined rate was already far lower.

Plus, as I mentioned, the Fed had already created and used so many other methods of pumping liquidity into the system.

But the Fed did what it did, knocking another 50 basis points off an already measly 2% Fed Funds rate. But the Fed was only one guest at a rather big party that took place in the middle of the week:

• The European Central Bank finally budged and knocked 50 basis points off its benchmark rate.
• The Bank of England followed suit with 50 basis points.
• The Swedish Riksbank cut by 50 basis points.
• The Bank of Canada cut by 50 basis points.
• The Swiss National Bank got in on the action by 50 basis points as well.
• The Bank of China knocked rates down by 27 basis points.
• The Bank of Japan offered their support, but made no change to rates.

Also note that a day before all these actions, the Reserve Bank of Australia sliced off 100 basis points. And a day after the rate cut party, central banks in Taiwan, South Korea and Hong Kong also joined in with rate cuts of their own.

When I say party, I mean it. Only investors never got the invitation to come share in the finger foods and free booze.

But at least the central banks were kind enough to toss some more easy money their way. After all ...

When Everyone's Already Heavily Indebted, What's Left to Do but Make Debt Cheaper for Them?

Here's the argument that central bankers and government officials make during crises like this:

1.   Individuals, companies and banks are having trouble accessing credit.
2.   This inability to secure credit is wreaking havoc on the growth of the economy.
3.   By cutting interest rates, credit is made cheaper and encourages borrowing that will in turn stabilize growth.

Well, in reality, it's not quite that easy or obvious. The government's solution is a lot like a marathon runner fueling his body with cotton candy ...

The runner may get quite a burst of energy from the cotton candy at first, but, sooner or later, his sugar high is going to peak and subsequently collapse.

And in an effort to keep from losing his sugar high completely, the runner just takes in more and more cotton candy. The problem is the cotton candy intake becomes increasingly less effective ... to the point of becoming unhealthy.

A sugar high can only last so long before it becomes a massive crash!

How could allowing cheaper access to credit, at a time when it's "completely necessary" for the economy to function, become unhealthy for the economy?

My answer is that it's not completely necessary.

The problem, as many have already mentioned, is a lack of confidence in the lending system. To a much smaller extent is the problem actually due to a lack of credit.

Easy access to credit — unnecessarily low interest rates and a "loans-for-everyone" mentality among banks — is what created the bursting bubble we're dealing with right now.

Cheap money and easy access to loans have bred projects of low value and low profitability. If money was more difficult and costly to secure, these investments would have never happened in the first place.

Artificially low rates attract any ol' Joe Schmoe who's got a business idea — no matter if it's building birdhouses out of popsicle sticks or selling cell phones to scuba divers.

Market determined interest rates, however, naturally weed out the birth of wasteful and absurd projects. This kind of growth is far healthier and more sustainable.

Surprisingly (and fortunately!) quite a few parties are learning lessons from excessive intake of credit. They're not feeling so good anymore. And so they're not willing to swallow any more cotton candy credit, no matter how cheap and how easily accessible it becomes.

What needs to happen is a period of cleansing and consolidation. Particularly with the banks.

Everyone needs to know which banks are solvent and which ones are being held together with paper clips and chewing gum.

The collapsing banks will need to liquidate. The solvent banks will be able to buy up assets on the cheap and solidify their own business. The result is a healthier entity that's ready to run again.

The cotton candy credit being dished out is going to keep everything running a little while longer, sure. But that's only going to delay the inevitable collapse of troubled institutions. And it will fail to restore confidence that some banks, who will actually escape this mess, will be willing to lend and borrow between one another at healthy, responsible rates.

In the end, of course, central banks make these decisions, not me. So ...

What Do the Rate Cuts Mean for Currency Investors?

Like the $700-billion dollar bailout, these rate cuts aren't going to have an immediate effect on the lending system or on confidence in the market. Let's just keep our fingers crossed that they have a positive effect at all ... ever.

To the specific point I've mentioned plenty of times in the last couple months ... the Federal Reserve is ahead of the curve on interest rates. It seems likely to me that they have less distance to travel on the downside with policy rates.

Major central banks around the world, on the other hand, have quite a bit of room to play with. The potential for rates to drop a lot further in European and Antipodean countries will sustain the exchange-rate rebalance that's currently working to the advantage of the greenback.

The ECB just got started on this rate cut business ...

The BOE just resumed a much needed easing trend ...

The RBA has gotten the rate cut momentum moving quickly ...

And the RBNZ has set a comfortable pace for cutting rates that is far from coming to an end.

So if you're seeing Fed rate cuts and automatically thinking the U.S. dollar will fall, you might want to get your brain off cruise control!

There are too many other factors that are going to keep the rates vs. currency trend in the U.S. turned upside down.

Am I saying that the U.S. dollar is officially out of its bear market? No. But things have turned up for the buck, even though it's counterintuitive.

As I see it, now's the time for the rest of the major currencies to feel the pain. And it's time for the buck to lead the way out of this mess that's engulfed the world's financial system.

Published on  Tue, Oct 14 2008, 14:53 GMT

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