The Race to Zero Interest Rates

With the global economic downturn in full swing, one of the burning questions on everyone’s minds is who will be the first central bank to take interest rates to zero and how close will everyone else get?

We are in a global easing cycle and the varying aggressiveness of central banks around the world means that any country could be the first to see zero interest rates.

We expect December to be another active month for the foreign exchange market as central banks around the world take their interest rates to historically significant levels. There are 4 central banks with monetary policy decisions in the first week of December and all 4 are expected to cut interest rates. The closest to zero is the Bank of Japan, but having been there before, they are reluctant to revisit those levels. The US Federal Reserve and the Swiss National Bank have the second lowest interest rates. Both central banks are expected to continue to ease, but the Fed has been far more open about going to zero interest rates than the SNB. Realistically, Japan and the US will probably be the only ones to take rates all the way down to zero. Switzerland should be left with the second lowest interest rate when the dust settles followed by the Bank of England.

What Happens After Zero?
When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last week, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Here’s where the major central banks stand and what is expected for the next meeting:

Federal Reserve – 50bp Cut Expected on 12/16

On October 29, the Federal Reserve took interest rates to 1 percent, which is near the record low reached in 2003 and 2004. While other countries have just started reacting aggressively to financial conditions, the Fed has been mounting cuts as far back as the middle of 2007. There has been no looking back since, as rates have been cut 425bp since 2007 and 250bp year to date. With interest rates near ultra low levels, the Federal Reserve has already resorted to unorthodox policy tools. More easing is expected with the markets torn between a 50 or 75bp rate cut in December. The FOMC statement will be particularly important this time around because the Fed will have the difficult decision of signaling a move to zero interest rates. In order to deal with this decision, they have expanded their monetary policy meeting from 1 to 2 days. Fed Chairman Ben Bernanke has remained dovish throughout the past few months which mean that another rate cut is practically guaranteed.

European Central Bank – 50bp Cut Expected on 12/04
Continue reading

Australia Central Bank Intervenes in Currency: Is it Worth the Effort?

For the third time, the Reserve Bank of Australia has intervened to support its currency which has dropped to a 5 year low against the US dollar.

Over the past month, the AUD/USD has fallen 25 percent against the greenback and 35 percent against the Japanese Yen.

As much as we applaud RBA Governor Glenn Stevens’ efforts, non-coordinated currency intervention rarely works.

Intervention has rarely resulted in a medium term top or bottom in a currency pair. We last saw that with the the Reserve Bank of New Zealand intervention in June 2007. The NZD/USD sold off for 200 pips, but it then quickly recovered those losses and went on to hit a 25 year high 2 months later.

NZD/USD Chart – June 2007 Intervention

The only way for intervention to work would be if it was coordinated with the Federal Reserve, the Bank of Japan and the European Central Bank. Although the BoJ may agree to yen weakness and Aussie strength, the Fed and ECB may not.
Continue reading

Another Failed Attempt at Stabilization

After the sharp volatility in the currency and equity markets during the Asian and European trading sessions, the US session was relatively quiet up until the last 10 minutes of trading. For most of the US session, stocks oscillated between positive and negative territory, giving traders hope that we may be finally seeing some stabilization. The last hour of trading has been wrought with surprises and today was no different.

The Dow tumbled more than 200 points 10 minutes before the market closed, driving all of the major currency pairs down with it. As we have seen throughout the past week, the US dollar and the Japanese Yen have been the biggest beneficiaries of equity market weakness. In this nervous market environment, investors do not need a reason to sell. With no buyers in the market, we have seen a low volume late day liquidation.

Going into the Asian trading session, this should lead to more weakness for the EUR/USD and USD/JPY.

Pressure on the Fed to Cut Interest Rates

As the dollar continues to strengthen, the pressure on the Federal Reserve to make a larger interest rate cut has grown. 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. 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. 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 only problem is that the next interest rate cut by the Fed will not be their last. The 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.

Dollar Rally May Not End After Presidential Elections
Continue reading