Currencies Soar as Fed Announces More Stimulus, GDP Not as Bad as Feared

US GDP growth has contracted but that has not stopped the equity and currency market from rallying. The GDP number was not as bad as the market had feared but what really drove the markets higher was the Federal Reserve’s new Term Asset-Backed Securities Loan Facility (TALF).

Both the outgoing and incoming Presidents are stepping on the gas and that is helping to restore investor confidence. President Elect Barack Obama has formed his Economic Team and is outlining his Economic Stimulus plan. The Bush Administration, bailed out Citigroup yesterday and has now made a colossal announcement aimed at putting a bottom in the asset market.

Their 35% increase in the Fed balance sheet represents another $800B worth of stimulus and will cause the Fed’s balance sheet to balloon to $3 trillion. For investors that have been concerned about the funding crisis, this is an even bigger reason to sell dollars.

Here is what the Fed announced minutes before the GDP number:

– New $200B facility to support ABS
– Buy up to $500B in mortgage securities backed by Fannie Mae, Freddie Mac and Ginnie Mae
– Buy up to $100B in direct obligations of housing related Government Sponsored Enterprises
– The Treasury will use $20B of TARP funds to provide credit protection to the Fed

Expect GDP Growth to Worsen

The 0.5% drop in GDP is mild when compared to past recessions and raises the risk of a sharp decline in fourth quarter GDP. Many people believe that the current downturn is the worst since the Great Depression and if that is true, we could easily see GDP fall by 4 or 5 percent in one quarter. In 2001, GDP contracted by 1.4 percent in the third quarter. In 1990, GDP fell by 3 percent in the fourth quarter and in the first quarter of 1982 GDP dropped a whopping 6.5 percent. There is no reason why the worst case scenario this time around is just a 0.5 percent contraction in GDP.

Remember That This is a Crisis of Confidence

However despite the pessimistic outlook for growth, it is important to remember that this was a crisis of confidence. So priority number one for the outgoing and incoming Presidents is to restore confidence. Since Friday they have done a good job with that if Obama outlines more plans at his speech later this morning, we could see the rally in the currency market continue. Don’t forget that the further monetary stimulus is also in the pipeline with the Fed expected to cut interest rates again next month.
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Dollar Hangs Tight on GM Risk, Recession Trades Still On

Signs of stability in the US manufacturing sector has failed to turn around the market’s risk appetite. Although the US dollar has weakened marginally against all of the major currencies, if US stocks continue to sell off, we could see the dollar regain strength.

Will the US government allow GM to fail?

The fate of General Motors will be the biggest event risk until the end of the month. In my opinion, the US government will not allow GM to fail. President elect Barack Obama has already pledged on numerous occasions to support the auto and retooling industry. To back off his promises so early in the game would be a reputation killer and not something the world expects from Obama. House Speaker Nancy Pelosi has also called on Congress to pass an emergency rescue package for the industry. Given that 1 in 10 jobs in America deals with the auto industry (from dealerships, auto parts etc), there is no question that the US government will extend life support to General Motors.

Nonetheless the longer the US government stalls, the more strain it puts on the financial markets, because investors don’t like uncertainty.

G20 Holding Out for Obama

The G20 meeting this weekend was also a big disappointment. With slightly more than 2 months to go before the US Administration changes, this was hardly a surprise because President Bush was not expected to commit his successor Barack Obama to any initiatives that he does not support. Since the group set an action plan for March 31 and another meeting for April 30, the G20 is clearly waiting for directions from Obama’s new Administration before putting the pedal to the mdeal. . The only problem is, the global economy may not be able to wait that long.

Recession Trades Still On
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FOMC Preview: Will the Fed Cut 25, 50 or 75bp?

The biggest event risk this week is undoubtedly the Federal Reserve’s monetary policy decision on Wednesday. Now more than ever, the Fed’s decision could turnaround the currency and equity markets. Since the last interest rate cut by the central bank on October 8th, the dollar has rallied more than 8 percent and the Dow Jones Industrial Average has fallen by more than 10 percent. The Fed’s half point rate cut at the time was a part of a coordinated effort with central banks from around the world including the ECB, the Bank of Canada, the Bank of England and the Swiss National Bank. With US interest rates now at 1.50 percent, the Fed will need to start rationing rate cuts going forward unless they want to take interest rates to zero.

Going into the FOMC meeting, economists can’t seem to agree on how much the Federal Reserve will cut interest rates. Of the 64 economists surveyed by Bloomberg:

53 percent expect a 50bp rate cut
26.5 percent expect a 25bp cut
19 percent expect interest rates to remain unchanged
1 lone economist or 1.5 percent of the people polled expect a 75bp rate cut.

Fed Funds traders appear to be more optimistic as they have already priced in 50bp of easing for Wednesday with a 32 percent chance of a 75bp rate cut.

The recent strength of the US dollar will add pressure on the Federal Reserve to make a larger interest rate cut but everyone needs to realize that the rate cut by the Fed this week will not be their last. Even though the national average of gasoline prices has fallen 35 percent, layoffs continue to rise. If GM and Chrysler are forced to cut back or worse, pushed into bankruptcy, unemployment will continue to grow. The US economy is expected to get worse before it gets better and the Federal Reserve will not want to back themselves into a corner quite yet; a larger rate cut on Wednesday would give them less room to cut interest rates in December.

Here are the 3 most likely outcomes for Wednesday’s monetary policy decision:

Coordinated Rate Cut by the Fed, ECB and BoE (Dollar Bearish)

The best and most effective option for the Federal Reserve would be to coordinate a rate cut with the European Central Bank and the Bank of England. All 3 central banks would get the most bang for their buck by working together. Given Monday’s comments by ECB President Trichet about cutting interest rates again in November, he may not be opposed to making the rate cut one week earlier. The Times of London has also indicated that the BoE is under pressure to cut rates as well. This measure of solidarity would send a strong message to investors and at the same time not require the Federal Reserve to take interest rates below 1.00 percent, leaving them little room to cut interest rates later. A coordinated rate cut to should be bullish for the global equity markets and bearish for the US dollar.

Independent 50bp Rate Cut from the Fed (Dollar Neutral)

Although a coordinated rate cut is the most effective option for the currency market, it may not be the most likely option because for whatever reasons, the ECB and the BoE may be opposed to coordinated intervention. Since an independent rate cut by the Federal Reserve is exactly what the market expects, the impact on the US dollar should be limited. The key will be the tone of the FOMC statement.

25bp Rate Cut (Dollar Bullish)

A 25bp rate cut will be a big disappointment to both the currency and equity markets. Given the degree of risk aversion and fear, we do not believe that Bernanke will risk the consequences of a disappointment since it could trigger another round of selling for stocks and high yielding currencies. In this type of market environment where investors are becoming immune to new measures taken by the US Treasury and the Federal Reserve, it pays to over deliver.

75bp Not a Viable Option – Too Close to ZIRP

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Fed Fund Futures Pricing in 75bp Rate Cut on Oct 29?!

The most anticipated event risk next week is the Federal Reserve’s interest rate decision. Going into the meeting, the market is now pricing in an 68 percent chance of a 50bp rate cut and an 32 percent chance of a 75bp rate cut.

This indicates that the market believes 25bp will be the minimum that the Fed eases on Wednesday. We believe that a 75bp rate cut will be a too aggressive because it leaves the central bank with next to no room to cut interest rates in case things get worse – and they will.

The 3 most realistic options are:

1. 50bp rate cut
2. 50bp coordinated easing along with other central banks
3. 25bp rate cut

A coordinated easing will probably have the most significant impact on the financial markets and given the drop in oil prices and the deterioration in European economic data, the ECB and the BoE may not be opposed to this option.

Although the Fed may have considered a 25bp rate cut earlier this week, they know that if they under deliver now, the consequences for the equity market could be severe. A larger interest rate cut could put a stop to the dollar’s rally.
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Coordinated Interest Rate Cuts – Too Little, Too Late?

We have been literally begging the Federal Reserve, the European Central Bank and the Bank of England to work together to stem the bleed in equities and they have finally done it (What is the Fed Waiting For? And Panic Selling in FX Begs Coordinated Easing). For the first time since Sept 2001, central banks around the world have delivered a coordinated interest rate cut. Coming 2 days before the G7 meeting and 1 day before the BoE interest rate decision, their move sends a strong message to market that the central banks are holding nothing back in their attempt to unlock the credit markets, stabilize the stock market and stimulate growth.

Given that the Bank of Japan stood aside, the move is bearish for USD/JPY. However the impact on the Euro and British pound is limited because the interest rate differentials between those currencies and the US dollar remain unchanged. Unprecedented is the buzz word in the financial markets these days and today’s rate cuts were nothing short of that.

Unfortunately despite an initial rally in stocks, equities have given back all of their gains as investors believe that the actions by the central banks are too little too late. This is undoubtedly the right move for the central banks, but the right time to have made the rate cuts was last Friday after the TARP approval. Stocks continue to sell off because this has not solved the funding issue. The LIBOR – OIS (Overnight Index Swap) rate hit a record high indicating that credit is still tight. The Reserve Bank of Australia’s full percentage point rate cut earlier this week has raised the bar.

Time for Halloween Treats – Next Stop Could be 1% for the Fed?

Given the market’s lack of a reaction to the rate cuts, the Federal Reserve may still give investors a Halloween treat by cutting interest rates 25bp at the end of the month and the next step after that could be a move to 1 percent.

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