Forex Investment and Currency Trading

Last week the markets moved to price in only a ¼% cut at the April 30th FOMC meeting. Longer term, the futures point to Funds rate remaining at about 2% this year, then starting to rise early next. Market still sees rates going down to 1% in this downturn but now expects the low may not be reached until 2009. This reflects the vew that the US downturn will be drawn out over an extended period as banks and consumers rebuild their balance sheets following the ongoing bust in the housing market. Three more quarter point cuts are now expected at the April, June and August meetings, but then the Fed will pause for a while at 1.5%. However, when the recovery proves disappointingly weak next year, further cuts, down to 1% will be seen.

Fed reluctant to cut too much. . .

The Fed has responded to the combination of a financial crisis and economic downturn with fast and furious rate cuts. This approach reflects the lessons of the 1930s and the Japan experience and is much influenced by Fed Chairman Bernanke’s own academic research in this area. But a series of Fed speakers have indicated their view that the Fed may have nearly done enough, for now. The problem is that, so far, the economic downturn is not sufficiently severe to be sure that it will kill inflation dead. Data mostly indicate a mild downturn and, even though the news is likely to worsen in coming weeks, there is a case for waiting to see whether the summer tax rebates plus the rate cuts generate a sustainable recovery. Moreover, there is a widely held view that the Greenspan Fed cut rates too low, stimulating the housing bubble. The Fed is anxious not to overdo the stimulus.

But weak data will force its hand

Market expects activity data to surprise on the downside in the next few months reflecting the sharp slide in consumer and business confidence this year. House prices are falling fast at present while gas prices at the pump are rising and now look likely to hit $4 per gallon in the summer, up from about $3.50 currently. The Fed will also be concerned by the rise in LIBOR relative to official rates as well as the jump in the Treasury curve in recent days which has pushed up long-term fixed mortgage rates once again. But the FOMC has probably done with large cuts now and instead will drip-feed 25 bps moves in the next 3 meetings. Then a pause after August is expected, to judge the impact of the fiscal stimulus and the cuts so far.

However, in both the last two downturns, the early 1990s and the early 2000s, the Fed continued to cut rates well into the economic upswing. The reason was essentially the same - a sub-par recovery with still-rising unemployment, falling inflation and continuing financial worries. In the 1990s there was the weakness of the banks after the commercial property bust. In the early part of this decade it was the bursting of the stock market bubble that held the economy back. Over the next 18 months it is very hard to see anything other than another very weak recovery. Banks are raising capital fast now but the losses will continue to mount as house prices fall and the recession unfolds with its usual toll of losses in other sectors including commercial real estate and credit cards. Meanwhile consumers face a major fall in their wealth (which is still only in the early stages) and a curtailment of credit, which is not going to change rapidly.

The economy should pick up a little in the second half. The fiscal stimulus will provide a lift over the summer, house-building will bottom out probably in Q4, ending the 1% of GDP drag seen for the last 18 months, and exports should continue to provide a useful boost. But the upswing looks unlikely to be strong. House-building will not bounce back as it usually does after a recession, commercial real estate construction is just starting to slow, business investment generally will stay lack-lustre or possibly decline, while state and local government spending will be cut back next year as governments react to weaker revenues. Crucially consumers will stay cautious. Overall, until GDP growth pushes back to 2.5% pa or above, unemployment will continue to rise while the financial sector will face increasing stresses as losses mount. The forecast is that after GDP growth of 0.6% this year, growth picks up only to 1.2% in 2009, with quarterly annualised growth not hitting the 2.5% rate until the second half of the year.

Interest rate stimulus less effective now

A key part of the Fed’s problem is that cuts in interest rates are less effective when balance sheets are being restructured, as Japan found to its cost. In theory lowering interest rates stimulates the economy by encouraging people to borrow and by raising asset prices. But the financial crisis means that the gap between official, or risk-free rates and bank lending rates has increased. Also, banks are being much more careful in their lending, looking for stronger cash-flows and better collateral. This is a function of a more cautious approach to risk as well as a shortage of capital in the banking system. Credit market participants have also rediscovered risk after the party of the last few years, which has left the securitised lending system in disarray However, it is not just a case of banks being unwilling to lend. The likelihood is that consumers are going to be much less willing to borrow in coming years, as they restore their wealth levels following the fall in house prices. A key reason for Japan’s slow growth throughout the 1990s was that corporates were paying down debt as they restored their balance sheets. Market expects the same from US consumers and that implies a significant rise in the savings ratio.

Meanwhile, arguably the most important asset price, real estate, will be falling for some time and this includes both residential and commercial. Lower interest rates can limit the downside but not prevent the unwinding of the housing bubble. Commercial real estate did not see a bubble like housing but there do seem to have been some “excesses” and prices will be under downward pressure given the recession. Cuts in interest rates probably have played an important role in holding stock prices up, but it is hard to see stock prices rising very much if profits are weak and there could easily be more downside. Perhaps the most effective channel for Fed rate cuts has been the declining dollar, which is helping to keep exports strong.

There is a strong likelihood of more fiscal action over the next year, both in the form of direct stimulus and measures to limit the downside for house prices. But the Fed will have to do its part too, cutting rates to 1% next year and market still does not rule out rates going lower still. The FOMC may assuage its inflation conscience in the next few months with a pause, but eventually it will need to cut rates further. By then inflation pressures are expected to be reduced with wage growth significantly slower and raised spreads on credit risks across the board.