Category — Interest Rates

Yesterday, we wrote that when the US sneezes, the rest of the world still gets a cold.  Now there are reports from DailFX.com comparing the Asian financial crisis of 1997-98 to the US subprime fiasco.  But while the starting points may be similar, there is reason to believe the reactions by international central banks will be different.

In 1997, traders and investors were highly leveraged in risky investments in emerging markets in Southeast Asia.  When the Thai government floated the baht, all hell broke loose.  In the current situation, traders and investors were highly leveraged into complex debt instruments backed by risky mortgages.  When foreclosures reached record highs, the credit market went into a state of panic.  If the parallels continue, then we should be looking at multiple interest rate cuts by the end of this year.

But the major difference in this case is that Fed Chairman Ben Bernanke has proven different than his predecessor Alan Greenspan.  Bernanke seems to be less inclined to bail out investors suffering in times of falling markets, especially if that bailout would include an interest rate cut.  Recent reports on Bloomberg indicate that the Fed has not decided on a course of action with regard to interest rates, instead hoping to give the increased liquidity time to work and the market time to digest the effects of the discount rate cut.  Senator Chris Dodd, Chairman of the Banking Committee, even pressed last night for more banks to take advantage of that rate cut.

That comment took place after a meeting with Secretary of the Treasury Henry Paulson and Chairman Bernanke.  The meeting was important on a number of different levels.  It occurred amid a backdrop of hawkish comments by a couple of Fed officials.  Futures traders, who had priced in a 100% chance of an interest rate cut in September, dropped their projections after the meeting to a 50% chance of a rate cut.  But one analyst for DailyFX.com still regards it as almost a certainty that the Fed will lower rates by at least 25 basis points (and maybe even 50) during their meeting on September 18.

The interesting thing about this scenario is that even in the midst of all these problems in the credit markets, the broader economy is still doing well.  Fundamentally, US growth remains on track, above the standard 2.0% level.  Unemployment remains low, and inflation seems to be relatively contained.  Even the debt market appears to be balancing itself out, as yields have begun to bounce back (the Fed is even considering accepting commercial paper a collateral for its discount loans).  Volatility is retreating, with the VIX down 30% off its 4-year highs last week.  Equities trades might cry foul, but the best decision right now might be to leave the Fed Funds rate unchanged.  And at least with regard to the foreign exchange market, that is good news for dollar bulls.

Yesterday, we stated that there would be little empirical effect of the discount rate cut on the international credit crunch.  Until the Fed actually cuts the Fed Funds rate (and that will not happen until September at the earliest), markets around the world are going to continue to be wary.  The equities markets are sending mixed signals about the health of the financial economy.  But the real signal is the credit markets because that is the epicenter of the crisis.  And it is there that we see the negligible effect of the Fed’s decision: yields on one-month and three-month bills are skyrocketing.

Asian stocks, led by the Nikkei, rebounded from their horrendous fall last week.  But European traders have been more cautious, and the net result on the Continent is a downward trend on equities.  The German ZEW survey of analyst sentiment did not help, printing at -6.0 vs. -1.0 expected.  Investors have been more accepting of risk than in recent days, as signs of a carry trade rebound have shown up in the market.  As evidence of that phenomenon, the yen crosses have begun to edge higher.

But looking at the credit market, there is still reason to remain bearish on international prospects.  Commercial paper is being avoided like the plague, not only in the United States but in Europe and Asia as well.  As an alternative, investors are rushing to US Treasuries, as they are really the only completely safe investment left.  Yields are being driven to multi-year highs.  Even the Bank of England, which stood on the sideline all of last week, is beginning to get involved in easing the credit crunch.

Forex sentiment on the US dollar is mixed.  The run of Treasuries should provide a strong support for bids at the moment.  But the housing recession and credit problems started here, and their final effects are likely to manifest themselves most strongly here.  Although that probably means bad news for the entire world, as when the US sneezes, the rest of the world still gets a cold.  Foreign exchange traders should remain bearish on the USD/CAD and bullish on EUR/USD and GBP/USD, especially considering the coming Fed Funds rate cut.

But there might be a problem with that scenario as well.  Recent reports show inflation in developing countries to be as strong as ever.  In China, the only real solution to that is to let their currency appreciate, something the government is still loath to do.  In India and Brazil, global demand has prices skyrocketing.  Developed economies may be experiencing a credit crunch, but emerging markets around the world may actually be confronted with excess liquidity.  A loosening of credit conditions in the United States could lead to an exporting of inflation internationally, and the primary job of a central bank (no matter what Bernanke or any politician might say) is still price stability.  Which means we might not see that rate cut in September after all.  And then we should prepare for all hell to break loose in the financial markets.

The Fed cut the discount rate from 6.25% to 5.75% before trading opened Friday morning, and US stocks responded.  Green numbers showed up for the first time in weeks.  The Nikkei rebounded from its shocking fall on Friday.  But it is impossible to tell right now if the cut will provide a lasting calm to financial markets worldwide.

There is a possibility for the Fed’s decision to have a big, positive effect on the credit market.  Much of the liquidity crisis has been a result of the inability of securities firms to obtain loans based on their assets.  The Fed has announced that it will take asset-backed securities and mortgages as collateral for the thirty-day (maximum) loans.  Securities firms cannot go to the Fed directly, but they can go to banks with their goods and the banks can go to the Fed.  In theory, this should solve the problems of the credit crunch.

But if you check out how the discount rate is used in practice, you see that the effect of Friday’s decision may be pretty small.  Only $11 million dollars changed hands last week through use of the discount window, a laughably small number.  A rate decision cannot really affect the market if no one borrows at that rate.

The real effect of the discount rate cut is probably psychological.  The decision signals that the bank is ready to do something to ameliorate the liquidity crisis.  The FOMC statement on August 7 was hawkish and preoccupied with inflationary risks.  The Bernanke Fed has prided itself on transparency, and in order to leave itself the room to lower rates in September or October, the bank needed to alter that statement.  Ignoring the effect of the financial crisis was a rookie mistake, but the Fed fixed that problem without indiscriminately bailing out the idiots of the subprime crisis.

The effect this will have on the credit market depends on the Fed’s willingness to lower rates.  If they do not cut the Fed Funds rate in September, we will see a resumption of instability and dollar-bullishness.  But the effect on the equities market is a little more complex.  Risk aversion should trend downwards, allowing for greed to surpass fear as a market mover.  But the fundamentals of the global economy are still troublesome, as the housing problems haven’t exactly gone away.  So investors should be wary of volatility; the VIX index registered its highest level even after the discount rate announcement.

For the US dollar, the Fed’s concern with economic growth over price stability is bad news.  Traders will now value the greenback’s safe haven status less highly.  An easing of the monetary policy should promote growth in the United States over the longer term; we are already seeing American growth outpace European growth for the first time in years.  And that phenomenon should continue.  But with investors hungry for yield and with the forex market as competitive as it is now, we are looking at a bearish outlook for the US dollar.

The discount rate in the United States was lowered today from 6.25% to 5.75%.  The 50 basis point reduction was a necessary move to stave off credit market gridlock (at the very least, it will satisfy Jim Cramer).  With regard to the foreign exchange markets, volatility is approaching the crazy days of October 1998.  The liquidity injections by the major central banks have obviously not been doing the job in easing the credit crunch, and the lowering of the discount rate sends a major message to the international financial markets.

The discount rate is the interest rate at which the Federal Reserve lends money to major banks, as opposed to the Federal Funds rate which is the overnight lending rate between banks (check out dailyfx.com for a more detailed look at the difference between the discount rate and the Fed Funds rate).  By not touching the benchmark interest rate, the Fed is trying to avoid the moral hazard problems.  Central banks around the world are loath to bail out completely the financial institutions that lent out money so irresponsibly.  But the economic impact on the borrowers and on the “real economy” has become so profound, that the Fed needs to do something.

When it comes to trading currencies, the primary effect of this morning’s decision is a removal of support for the US dollar.  Accompanying the discount rate announcement was a dovish statement by the Fed stressing economic growth and deemphasizing the fight against inflation.  A September 18 rate cut is as close to a certainty as is possible.  But that weakness is compounded when you realize the psychological effects of the Fed’s decision.  Now we know that the US central bank stands at the ready to ensure proper credit movement, and with removal of some risk, more daring investments come into play.  And there’s less of an incentive to hold cash (or T-bonds, which are just about the same thing).  People do not care anymore about the US dollar’s safe haven status, and that is reflected by the fact that the currency fell against 14 or the 16 most highly traded currencies.  Dollar bulls are going to eat some losses now, but today’s news is good news for the global economy as a whole.  And ultimately, that’s good news for the dollar.

The Dow sold off below 13K yesterday, foreign purchases of US securities were mixed and the market has already priced in an interest rate cut in the United States at the Fed’s next meeting on September 18.  But the US dollar has shrugged off that data and continued to remain strong, at least against every major currency except the Japanese yen.  I am particularly bullish on US Treasuries as most of the rest of the bond market is particularly illiquid and difficult to price.  Treasuries are the surest bet for investors.

The gains against the commodity currencies are especially striking.  Commodities continue to fetch high prices in the futures markets, but the currencies themselves are feeling the effects of the recent appreciation.  Canadian production has fallen as a result of the strong Loonie, and investors are becoming more wary about bets placed in New Zealand and Australia.  Fundamentally, long positions in NZD/USD appear to be the most at risk.  With traders paring back on riskier strategies and sticking to the US dollar, look for the commodity currencies to continue their falls.

The interesting thing about the strength of the dollar is the lack of good economic data to support that strength.  The CPI report was flat, and the subprime problem seems to be contagious, rather than contained.  The New York Fed was hot, buy Housing Starts fell to a 10-year low in July.  The housing sector is mired in an 18-month recession.  If the Fed needs an excuse to lower interest rates, there’s plenty of poor data it can point to.

Speaking of interest rates, I will be very surprised if we do not see one on September 18, but just as surprised if we see one before then.  Bill Poole has come out and said that it would take a calamity for the Fed to introduce an emergency rate cut.  Mark Gilbert of Bloomberg brings up an interesting point though: the liquidity injections into the market by the Fed have already brought the 4-week Treasury bill below the target rate of 5.25%.  A temporary easing has already occurred which leaves the September 18 meeting to just make it official.  And when that happens, look for the dollar to lose its support.  But not until then.

Should the US Fed lower its overnight lending rate, and what will its decision mean for the US dollar?  The short-term strength of the greenback would surely disappear if rates were indeed lowered in September.  But just as certain is that financial markets would recover faster, and the economy might be stronger going into the end of 2007.  the danger of cutting interest rates (besides the inflationary risks) is the idea that a market bailout by the Federal Reserve would create a moral hazard in the financial industry.

Short-term support for the dollar remains strong.  The dollar is on a steady upward path against the euro and the pound.  It is absolutely killing against commodity currencies.  With risk aversion still dominating the forex market (and the carry trade likely to fall even further), the yen remains the only currency to show strength against the US dollar.  If USD/JPY touches 116.50, we will see all hell break loose; that’s the level at which many retail traders started shorting the yen and their stops will come into play.  Economic data for the greenback has been mixed.  Industrial production and producer prices surprised to the upside.  But the CPI report this morning came in particularly low, as many economists were predicting.

The last development would provide cover for the Fed if Bernanke decided to bail the financial market out with an interest rate cut.  Monetary policy makers could argue that the upside risk of inflation is abating, thereby preserving their inflation-fighting credibility.  But one thing to note is that the liquidity that has been injected into the market in recent days has not exactly been a “helicopter drop.”  The money has gone through the big banks, and there are still reports of smaller companies and mortgage lenders being mired in a liquidity crunch.  The signs of the intervention working are mixed, at best.

But then that points to an interesting question.  Should we bail out lending companies that made foolish decisions resulting in bad loans?  If the financial companies are not held accountable for their poor actions, then we could see even riskier investments and loans flourish in the new environment.  The ideal scenario would be to find some way to help those families stuck paying off impossible mortgages and keep them from losing their homes, but do that without assuming the risk of the larger corporations.  An actual helicopter drop, distributing money to those at the bottom-end of the operation, would be best.  The government would need to get involved.  However, the integrity of the Fed and the US dollar would be maintained, and US consumers would be saved.

Traders and investors in financial markets around the world are preoccupied with paring back their risk exposure.  Internationally, emerging market investments are being cut back.  In the US equities market, stocks are losing attractiveness in favor of safer Treasury bonds.  With regard to the foreign exchange market, traders are shunning the risky carry trade.  The ultimate consequences of all this activity are strong support for the US dollar and the Japanese yen and a decline in the other major currencies.

The greenback’s rise is interesting.  With America at the locus of the subprime crisis, its currency is also the greatest beneficiary.  When risk rules the market, traders park their money in dollars, and that is likely to continue for some time.  EUR/USD acts as a proxy in the FX market for dollar sentiment, and the euro is on track to take a beating.  Economic data from the continent has also disappointed, while US Retail Sales surprised to the upside.  Unless the Fed surprises everyone with an immediate interest rate cut, dollar bulls should continue to smile.

The Japanese yen has been the other recipient of good fortune during this subprime mess.  All of the high yielders have taken turns falling against the yen.  Technical analysis points to now being the turning point for GBP/JPY.  But while the carry trade unwind is driving this growth in the yen, economic data in Japan is not supporting the rebound.  And so a long-term outlook in the currency cannot be positive.  The Bank of Japan does not have a basis to raise interest rates, and the yen will suffer accordingly.

Central banks are the major players in the FX market in this current environment.  Will the increased liquidity ease credit concerns?  Many analysts predict that the banks will be forced to concede inflation and lower rates to stave off a world-wide recession.  But predictions of this hard landing are wrong.  The market correction should even itself out, and the increase of money in the market should keep buying and selling going.

The European Central Bank and the United States Federal Reserve are bailing out the financial markets right now.   BNP Paribas declared that they are suspending withdrawals from three of their investment funds, and the market reacted pretty poorly.  The overnight lending rate for euros shot up to 4.7%, leading the ECB to distribute over 155 billion euros over the past two days.  The Fed, which has seen two straight days with the LIBOR rate above the benchmark rate of 5.25%, has added $43 billion in temporary cash.  The Bank of Japan and the Reserve Bank of Australia, this morning, added $8.5 billion and $4.2 billion, respectively.

Risk aversion has been on a steady climb recently, and naturally, the demand for liquidity has skyrocketed.  Central banks around the world have used their tools to ameliorate the crisis.  The real problem is what message this sends to participants in the financial markets, whether it be equities or foreign exchange.  The last time there was a bailout this large was right after September 11, 2001.  Earlier this week, both the ECB and the Fed were talking about how credit conditions were manageable.  The Reserve Bank of Australia raised its interest rate to 6.5%.  The Bank of England basically came out and said that they were ready to keep raising interest rates for the near future.  What do the central banks know now that has caused them to change their positions?  And what do the commercial banks in Europe and America know that led them to accept the loans?  Is the US subprime crisis a worldwide issue now? Bear Sterns Chief Financial Officer Samuel Molinaro came out and called this the worst fixed income market that he has ever seen.  And the primary driver for investors is fear, fear of what the answers to those three questions are.

It would be a different scenario if it was only firms on Wall Street losing money.  It would hurt the US economy, but the influence would be limited.  But what a liquidity crisis means is higher interest rates.  For everyone.  Analysts across the spectrum have been chirping about how the era of easy money is over.  There are billions of dollars worth of adjustable rate mortgages that still need to be re-priced according to current interest rates in the coming months.  The housing situation is on track to get worse, with foreclosures even higher than before.  About seven million Americans are slated to lose their homes.  And with homes so important to personal equity and wealth, the problems will stifle individual growth and consumer spending.

In the short-term, the US dollar actually benefits from market uncertainty.  Risk aversion and volatility (Chicago Board of Option VIX survey is at a 4-year high) lead traders to park their assets in US dollars.  Counterintuitively, the US subprime crisis puts support under the US dollar.  But it’s time for the Fed to ease credit.  What has been done so far is not enough, and interest rates have to be lowered; money has to be thrown in to the financial markets.  The lower interest rates will counteract the safe haven status of the US dollar for now, but it is what is needed for the US economy to get through this situation.  Lower interest rates and greater liquidity will hurt dollar bulls in the short-term, but they will benefit the US economy (and therefore the US dollar) in the long-term.

The actual interest rate decision yesterday afternoon did not surprise anyone in the forex market. The Fed kept rates the same which, despite the bank’s famous lack of transparency, was predicted by everyone. The announcement accompanying the FOMC decision did provide some short-term support for dollar bulls. But of greater concern for most forex analysts, the longer-term problems afflicting the US dollar are not likely to go away anytime soon.

According to the announcement, the primary concern for the Fed is still trying to control inflation, which is certainly reassuring for those still long US dollar. There are two primary reasons for this track. The first is that the bank looks to be providing a calming voice to the international financial markets. While accepting that the housing crisis is troublesome (and could get worse), the situation is not as bad as it might seem.

Analysts all over the United States are screaming their heads off about the problems in the subprime sector and how they are going to sink the market and how the central bank needs to cut interest rates. But the fact remains that the broader economy continues to do well. And despite the Fed’s dual mandate (of controlling inflation and ensuring economic growth), the fact remains that the bank’s primary job is price stability. While core inflation may be within the target range (1-2%) espoused by Bernanke’s Fed, commodity prices are skyrocketing. Oil is still above $70/barrel and food prices are growing at a 6% annualized rate. The upside risks to inflation remain high, informing much of the bank’s decision to keep interest rates the same.

The second major reason that the FOMC kept interest rates steady is the need to keep returns competitive with the rest of the world. Interest rates are on the rise all over the world, and if the United States lowers its rate, investors realize they can better return to equity elsewhere; US bonds would be inherently less attractive than bonds offered by countries with lower rates. The market still expects interest rate cuts by the beginning of next year, which leaves the US yield curve inverted.

Traders, before anything else, are obsessed with higher returns, and if they cannot find them in the United States, we will see a capital flight away from this country, torpedoing the US dollar. Deterioration in our current account surplus would leave American consumers unable to pay for imports in the short-term, setting the stage for a massive devaluation of the US dollar. The greenback is buoyed by its status as a store of value and by the dollar’s preeminence in international trade, but that’s not going to matter to investors hungry for yield. The Fed’s caught between two problems: the slowing down of the US economy and the need to keep US bonds attractive to international investors. It is this situation that will keep US interest rates the same for some time, keeping a cut at bay for longer than most forex analysts seem to think.

The state of the US economy is not dire, but it certainly does not bode well for the US dollar.  Job creation was at its lowest level since February, with the NFP printing at an abysmal 92K.  But even worse for the dollar is the fact that job numbers are not the cause of growth or decline in the economy.  Payrolls are a reflection of demand; as house prices depreciate and take personal income down with them, that creates less of an incentive for businesses to grow.  In recessionary times, businesses are always slow to cut jobs, as the fall in labor always lags behind the fall in production.  The chance of a US recession will lead the greenback to fall against all the other major currencies.

As of right now, however, the idea of a recession is a little overstated.  But even if the economy is only stumbling (and will pick up later in the year), the US dollar is still going to take a hit.  That is because in this current market, equities are on line to fall even further.  US stocks have already been underperforming for years now compared to foreign equities markets.  And with fixed income in the United States more and more attractive because of the rising risk aversion among traders, that phenomenon is only going to continue.

Even the Fed policy meeting on Thursday is not likely to improve the mood of traders or dollar bulls.  That interest rates will stay the same is a market consensus, and Bernanke seems less inclined than his predecessor to act as a stock market savior.  The “Greenspan Put” should be pronounced dead, and forex observers can expect the announcement on Thursday to remain hawkish on inflation.  The futures market is pricing in a 100% chance of an interest rate cut in early 2008, but I believe the Fed funds rate will remain at 5.25% through the end of 2008.

The problems in the US housing market are a concern, however.  American Home Mortgage declared bankruptcy this morning, becoming the second-biggest lender to do so amid the subprime fallout.  Bear Sterns continues to take hits, with S&P announcing a negative on its debt rating.  The primary beneficiary of the weakness in US assets is the euro.  Ever since its inception, the euro has acted as the anti-dollar, providing an alternative for currency traders soured on the US market.  That is certainly the case right now, as euro bulls are having a field day.  Look for EURUSD to test 1.3900, and if it can overcome the resistance there, then the pair should see clear sailing through 1.4000.

After the euro, the other major currency to benefit in this forex climate is the Swiss franc.  Look for the Swissie to be the biggest gainer against the US dollar this week.  The low-yielding currency has found support as the carry trade has unwound.  As painful as carry trade unwind has been for those shorting the franc, history tells us that we are not even close to done yet.  The franc already hit a two-year high against the US dollar early this morning, with USDCHF reaching 1.1868.  The Swiss franc is both a growth story and a safe haven in a time of risk aversion, making it extremely attractive to currency investors.