Euro and British Pound Crushed by Rate Decisions

The Euro and British pound have come under severe selling pressure after the ECB and BoE cut interest rates by 50bp. Interest rates are now at historic lows for both central banks and even though the rate announcements were negative for both currencies, the Euro has sold off more aggressively than the British pound because ECB President Trichet warned that growth will be signicantly reduced in 2009 and 2010 while inflation will remain well below 2 percent.

More importantly, he admitted that the ECB is studying non-standard measures which include quantitative easing. However, Trichet prefers to use the Fed’s label of credit easing over quantitative easing (What is the Difference Between Credit and Quantitative Easing?). The mere possibility that the ECB could consider Quantitative Easing was enough to drive the EUR/USD below 1.25. With the third highest interest rate of the G10 nations, further interest rate cuts are still possible. By saying that they have not made a decision about whether 1.5 percent is the lowest level makes 1 percent interest rates a real possibility for the Eurozone. In fact, Trichet may opt for another rate cut before credit easing. For the US dollar, British pound and Japanese Yen, no surprises are expected from future rate decisions. However for the Euro, the prospect of lower interest rates and the uncertainty of if and when the ECB will adopt credit easing should keep the EUR/USD under pressure.

Bank of England: Rates May Have Hit Rock Bottom

As for the Bank of England, I believe today’s 50bp rate cut to 0.5 percent is their last. The central bank has been worried that excessively low interest rates would erode profitability of banks, reducing their incentive to lend. Now that they have been given the authorization to begin Quantitative Easing, it will be their new focus. UK Gilts have soared on the announcement that the government will purchase up to £100bn in Gilts and £50bn in private sector assets (syndicated loans and ABS). As we indicated in our ECB and BoE preview, Quantitative Easing is negative for a currency, but if the BoE is done cutting interest rates, further weakness in the British pound may be limited.

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Bernanke Rebrands Quantitative Easing as Credit Easing

For the first time since cutting interest rates to 0.25 percent, Federal Reserve Chairman Ben Bernanke outlined his plan of action. In a speech at the London School of Economics, Bernanke talked about the additional tools available to the Fed, an orderly exit strategy, concerns about inflation and suggestions about how the Obama Administration should use the remainder of the TARP funds.

What is the Difference Between Credit and Quantitative Easing?

Most importantly, Bernanke created a new name for his regime – credit easing. In contrast to Quantitative Easing, which Bernanke explains focuses on the liabilities portion of the central bank’s balance sheet, Credit Easing focuses on expanding the asset side of the balance sheet. However since the balance sheet is suppose to balance, this may just be a difference of semantics since both efforts ultimately add liquidity into the financial system. The Federal Reserve wants to draw a distinction between their current policies and the Bank of Japan’s policies between 2001 and 2006.

The Fed’s Toolbox

As for the tools that they have at their disposal, there was nothing groundbreaking. Their number one tool is policy communication, followed by liquidity facilities for banks, facilities for other markets and purchases of long term securities. Like Federal Reserve President Lockhart, Bernanke expects interest rates to remain low for an extended period of time.

Inflation Concerns and Exit Strategy

As we expected, inflation is not a concern because the Fed believes that weaker growth will keep inflation low. In terms of an exit strategy, he expects demand for the emergency facilities to wane as the US economy improves.

Use of TARP Funds
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