The biggest debate in the currency markets at the moment surrounds what the Federal Reserve will do on September 18th. We expect the upcoming interest rate decision to create a great volatility in the financial markets because with less than a week to go, economists and traders have yet to reach a consensus on how much the Federal Reserve will lower interest rates, if at all. According to the 117 economists surveyed by Bloomberg, 69 percent expect a quarter point cut, but according to a DailyFX Poll of 255 voters, only 48 percent expect the Fed to move.
It has become painfully obvious that Federal Reserve Chairman Ben Bernanke has encountered the "first year curse," where new Fed Chairman are faced with a major financial crisis shortly after taking office. The recent rally in the global equity markets and the sell-off in the US dollar indicate that some type of easing is expected, but the question is still, "do current conditions and future outlooks warrant a 25 or 50 basis point rate cut?" In our opinion, this is really a question of whether the Fed chooses to deal with the problems in the US economy proactive or reactively. A 25bp cut would be putting be a band aid on the subprime and credit crisis in hopes that the problem does not exacerbate while a 50bp cut would represent an aggressive move by the Federal Reserve to tackle the problem before it worsens.
What Kind of Economy Is The Fed Grappling With?
While the markets have been speculating for weeks that the Federal Reserve will move to lower interest rates on September 18th, the release of dismal labor market data on Friday, September 7th essentially cemented the prospects of a rate cut. US non-farm payrolls declined for the first time in four years during the month of August. The 4k drop was particularly dour against estimates of a fairly strong reading of 100k. Surprisingly, the unemployment rate remained unchanged at 4.6 percent, but this was largely a function of a drop in the labor force participation rate to its lowest since 1988. Countrywide Financial Corp. added to the gloomy sentiment by announcing later on the same day that the firm would cut 10,000 to 12,000 jobs – about 20 percent of the company's entire workforce. With the housing recession only worsening and likely to seep into other areas of the economy, the situation for domestic laborers is likely to grow increasingly worse through the medium term.
The collapse of the subprime mortgage market and subsequent impact on the labor market could have other negative effects as well. First, household sentiment has already started to take a hit as the Conference Board's consumer confidence index fell during the month of August to a one year low of 105.0. A breakdown of the index shows that Americans are far less optimistic, as the number of people indicating that they expect business conditions to worsen, fewer jobs to be available, and income to decrease within the next six months all picked up. This gloomy sentiment signals that consumption growth could suffer, especially as volatile financial markets and high gas prices are unlikely to abate in the near-term. Thus far, US retailers have performed fairly well, as the International Council of Shopping Centers (ICSC) recently reported that August chain-store sales saw 2.9 percent increase from last year. However, it appears that most of the improvements came as a result of massive discounting, as chains like Wal-Mart and Macy's have slashed prices in order to draw customers, which has the potential to slim-down profit margins. Retailers won't be able to use these tactics forever, and a slowdown in consumption is likely to show through eventually. Even retailing executives are leery about the outlook. Last week Myron E. Ullman, chief executive of JC Penney said, said in reference to shoppers' anxiety about the economy, "It will be tougher than it is now. I do not see anything on the horizon that will turn this around." With the US consumer responsible for almost 70 percent of GDP, the risks for a sharp slowdown in economic expansion in Q3 and Q4 rise dramatically.
It's Not A Matter Of If They Will Cut, But By How Much…
Given the feeble condition of the US economy, and the even more fragile outlooks, there is little doubt the Federal Reserve will cut rates in September. According to the Fed Fund futures curve there is a greater chance of 75bp of easing than no cut at all. The consequences of unchanged rates would be severe. The entire yield curve would be repriced and the stock market would collapse. Therefore the more important question is: will the Fed deliver a 25 basis point cut or a 50 basis point cut?
25 Basis Points
A 25 basis point cut following the Federal Reserve's September 18th meeting is very much priced into Fed fund futures and has been ever since August 9th, when the liquidity crunch initially hit bond and equity markets. In fact, just a day prior, the markets were pricing in only a 20 percent probability of a September cut and 100 percent chance of only one 25 basis point reduction by the end of the year. Of the 117 economists surveyed by Bloomberg 81 indicated that they thought the central bank would reduce rates to 5.00 percent during the third quarter. This slower approach to loosening monetary conditions may be preferred by the Federal Reserve, as Bernanke will likely want to allow time to gauge the impact of their previous policy actions. Furthermore, the US dollar, carry trades, and equity markets may be more even-keeled in coming months as a less extreme policy move in the near-term would create the potential for additional policy action in the long-term. Nevertheless, traders should count on a spike in volatility on the announcement of any policy decision and sustained weakness in the US dollar as long as the Fed is expected to cut rates again. Keep an eye on the FOMC statement
50 Basis Points
As we mentioned above, a 25 basis point interest-rate cut is already priced in for September, but what about a more dramatic cut? At the time of writing, Fed Fund futures show a greater than 50 percent chance of a half-point cut to 4.75 percent, however, only 24 out of 117 economists polled by Bloomberg agree with this outlook. However, given the sharp decline in last Friday's non-farm payrolls report, this outcome has become more realistic and of the equity markets start to get pummeled once again, the probabilities of such a move will only increase. Over the next few months, a 50 basis point cut may prove to be the most bullish for equity markets, who will breathe a sigh of relief, but bearish for the US dollar as interest rate differentials would be quickly out of favor for the currency.
What About the US Dollar and Carry Trades?
One of the most surprising things we initially saw in the forex markets when global stocks were first sent reeling in early August was the fact that the US Dollar strengthened against currencies like the Euro and British Pound, while carry trades unraveled at a frightening pace. However, we saw this dynamic shift on September 5th, when US pending home sales were released at a horrid -12.2 percent. The news was so bad that it cemented the prospect of lower US interest rates in the minds of forex traders, sending the US dollar plummeting against the majors – including the Japanese yen – even as the Dow tumbled 150 points. The shift also signaled that the greenback was no longer being utilized as a safe-haven asset by international investors. Since then, the financial markets have stabilized somewhat, with carry trades and equity markets moving in tandem, while dour US economic data leads the US dollar to weaken.
Going forward, the potential for policy action by the Federal Reserve will make the US dollar less attractive amidst lower interest rates and slower growth prospects. In fact, the US dollar doesn't stand much of a chance of strengthening significantly in the near-term unless the central bank does the unexpected: leaves rates steady. This decision would quickly bring back the scenario where the US dollar rallied as a safe-haven asset while US equity markets crumbled.
Meanwhile, the status of the once-lucrative carry trade will remain contingent upon the status of equity markets, which has served as an excellent barometer of the risk-seeking nature of forex traders. As a result, if policy action (or lack of it) by the Federal Reserve fails to leave Wall Street satisfied, the profitability of carry trades could deteriorate further. On the other hand, rate cuts by the central bank, especially successive ones throughout the next few months, will send pairs like GBPJPY and EURJPY rocketing higher.