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Surprise, surprise — the Federal Reserve cut interest rates this week. Okay, maybe it was no surprise, but the precise action taken by the Fed caught quite a few know-it-alls off guard.
I say that because, leading up to the Fed’s announcement on Tuesday afternoon, the market was overwhelmingly betting on a full-percentage-point rate cut.
Now, it’s worth pointing out that the Fed had already taken other steps a few days earlier. On Sunday, it cut the discount rate and opened up its discount window to make it cheaper for commercial banks and institutions to borrow money. The Fed also agreed to back the already infamous Bear Stearns buyout.
Perhaps that’s why they opted to only cut rates by 75 basis points on Tuesday.
But there are two important questions yet to be answered …
Is Less-Than-Expected Good Enough This Time?
And Are These Simply Acts of Desperation?
Initially, the stock market seemed happy enough with the 75-basis-point cut — the Dow Industrials rallied more than 400 points the day of the announcement.
Of course the market gave back much of those gains the very next day. That’s one of the reasons I have to step back and wonder whether the Fed fell short this time; whether they actually needed to go the distance.
I think it’s going to take quite a bit more to restore confidence in the system. The Fed will need magic to keep the wheels of the U.S. economic and financial machine greased until we power our way out of this mess.
By the way, in addition to that 75-basis-point cut, the Fed pulled out a whopping dose of inflation rhetoric. It was a bit excessive, but they probably just wanted to make the point that they haven’t forgotten entirely about rising prices.
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What the Fed’s Move Did to the U.S. Dollar …
The announcement the Fed served up on Tuesday sparked a small dollar rally. However, I don’t think it can last, and I expect the Fed’s smoke-and-mirrors tactics will wear off rather soon.
Why? Because there are no signs that the Fed Funds rate is anywhere near a bottom. And there are no signs that the Fed has restored confidence in credit markets, financial markets, equity markets, or even farmers’ markets!
They’ve simply deflected the latest round of concerns in hopes of stemming the next inevitable round of worry from surfacing. And considering the host of threats weighing on the dollar, nothing short of an epic maneuver by Ben Bernanke and his cast members is going to help.
That’s why I say …
The Fate of the Dollar Actually Rests
In the Hands of the European Central Bank!
The fact is that major central banks are in an ongoing battle to maintain prices and economic growth, and the Fed is losing this battle big time.
Conversely, most other major central banks have thus far done a sufficient job at fighting off threats similar to those penetrating the walls of the Federal Reserve.
And by far, the biggest factor pushing the dollar to its current depths has been its disintegrating yield courtesy of Fed rate cuts.
As you can see from my chart, the current Fed Funds rate of 2.25% now sits BELOW those of the Reserve Bank of New Zealand, Reserve Bank of Australia, Bank of England, European Central Bank, Bank of Canada, and the Swiss National Bank. Only the Bank of Japan’s benchmark rate falls short of the Fed’s!
Unless that yield differential narrows, the potential for a major dollar advance is limited.
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As I already pointed out, little action will be taken on the home front that could result in a strengthening dollar. But I think the European Central Bank could initiate a significant shift by cutting its benchmark rate.
I see two reasons for rate cuts from the ECB:
First, economic weakness in the Eurozone. The Euro area hasn’t suffered nearly as much pain as we have in the U.S., but there are signs that things are worsening.
Second, the surging value of the euro. So far, the ECB has kept interest rates unchanged to prevent inflation from becoming a detriment to the economy. But the rising value of the euro could change that …
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As the euro rises in value, the region’s exports become less competitive, and economic growth is put at risk.
One measure I’m watching is euro’s trade weighted index (TWI), an exchange rate measurement that factors in a country’s contribution to global trade. As the euro’s TWI increases, the Eurozone’s GDP shrinks and inflation follows.
It’s worth noting that the declining dollar is the biggest threat to the euro’s TWI right now. In other words, the ECB might not want the euro to become too valuable relative to the greenback.
All of this gives the ECB reason to ease up on the throttle and become more accommodative with its monetary policy. Now, exactly how high the euro will have to go before the tide turns is anybody’s guess. Will it first be worth $1.60 … $1.70 … $1.80? I guess we’ll know when ECB President Jean-Claude Trichet’s nose finally starts to bleed!
Best wishes,
Jack
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