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Daily Currency Market Focus

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Will a Fed Rate Cut be Enough of a Lifeline to Save the Market?

Tue, Sep 16 2008, 08:13 GMT
by Kathy Lien

GFT

FED MEETING: 64% CHANCE OF RATE CUT, WILL THIS LIFELINE SAVE THE MARKET?

Since the beginning of the year, we have lost 3 of the largest investment banks on Wall Street and such unprecedented developments have called for unprecedented actions by US government and Wall Street officials. Since the announcement of Lehman Brothers filing for bankruptcy and Bank of America taking over Merrill Lynch, AIG has been given special permission by US authorities to tap into $20bln of its own capital to prevent a liquidity crisis and credit downgrades. The Federal Reserve is also holding a special meeting to discuss possible remedies to AIG’s problems. The ECB and the Bank of England have pumped more liquidity into the financial system while the Federal Reserve made an unusual intervention to drive Fed funds lower.

Why Did Fed Funds Soar to 6 Percent when Futures are Pricing in a Rate Cut?

Fed fund futures are pricing in a 64 percent chance of a 25bp rate cut tomorrow by the Federal Reserve. This is a big change from last week, when the only thing that the market was thinking about was a rate hike. However despite this sharp shift in expectations, Fed funds surged to a high of 6 percent, 400bp above the Fed’s target rate of 2 percent intraday. This jump in the overnight lending rate between banks indicates that no one wants to take on risk. Trust is a commodity these days as the move in Fed fund futures suggests that no one knows if their counterparty will be here to survive another day. Fund funds gave back all of its gains by the end of the US trading session, but that does not mean that risk appetite has returned – quite the contrary. AIG is in big trouble, Washington Mutual is still on our watch list with their bonds now cut to junk status by Moody’s and the worries now turn to Goldman Sachs and Morgan Stanley who will be releasing earnings this week. Large write downs could drive a nail in the coffin for the US stock market and USD/JPY. Of all the pairs in the currency major, USD/JPY and other carry trades will be hit the worst. Over the past 3 years, there has been a 68 percent correlation between the VIX and USD/JPY - higher volatility means trouble for the currency pair. Although consolidation in the banking sector was something many people expected, no one thought that the consolidation would occur because of Chapter 11 filings.

Will a Fed Rate Cut be Enough to Shore Up Confidence and Trigger a Reversal in the US Dollar?

So far, the efforts of the US government have failed to bring any stability to the financial markets. Stocks dropped more than 400 points today, 2 year bond yields plunged a jaw dropping 40bp while the repatriation has lifted the dollar against everything except for the low yielders. Traders are now turning to the Federal Reserve for help, but a rate cut, may not be enough to shore up confidence. In addition to balancing growth with inflation, the Federal Reserve is also responsible for maintaining stability in the banking sector and right now, they need to step up to the plate because judging from the price action in the markets today, expanding lending facilities and adding $70 billion of temporary reserves to the banking system is not enough. With oil prices below $100 a barrel, the economy deteriorating, the financial markets in disarray and the Dow Jones Industrial Average down more than 15 percent year to date, there is no reason for the Federal Reserve not to cut interest rates. However, the more important question is whether or not a rate cut will be enough to put an end to the volatility. In our opinion, it is not enough. Even if the Fed cuts interest rates, that may not reduce the true cost of borrowing and relax terms of credit. Default risk is the market’s biggest problem and is the primary reason why reducing risk, dumping exposure and repatriation is the one cohesive theme that we are seeing across the financial markets.

This dynamic continues to drive the dollar higher despite the systemic risk and why it’s performance against the low yielders (yen and Swiss franc) is dramatically worse than its performance against the other majors. However, if the problems exacerbate, Sovereign Wealth Funds may start dumping their US investments, which would start turning the systemic risks from dollar positive to dollar negative

Published on  Tue, Sep 16 2008, 08:18 GMT