Why the Fed Needs to Cut More Than 100bp

Last week, we warned that the Federal Reserve is on high alert and now, we understand why. Pandemonium has hit the financial markets as the US dollar trades below parity against the Swiss Franc for the first time ever, hits a record low against the Euro and a 12 year low against the Japanese Yen. Bear Stearns’ demise has sent shockwaves across Wall Street and everyone is holding their breath for the next shoe to drop.

After surprising the markets with a 25bp discount rate cut on Sunday and extending the discount rate window to investment banks, the Federal Reserve is set to make another historic move by cutting interest rates 100bp tomorrow. This would be the first time in over 23 years that the central bank has cut interest rates by more than 75bp during the single meeting, reflecting the severity of the current US economic situation.

In reaction to the Fed’s move, the Bank of England and the Bank of Japan have also injected liquidity but the Fed’s efforts have been futile thus far as banks refuse to take on more counterparty risk. Bond yields are also down significantly. The 3 month t-bill rate fell to the lowest level in over 50 years while the 2 year treasury bond yield fell to the lowest level in 5 years. This tells us that the Federal Reserve will need to cut interest rates by more than 100bp. In fact futures traders already expect rates to come down to 1.25 percent by the end of June.

However, if Bernanke really wants to reassure the financial markets, he should cut by 125bp tomorrow and come up with more creative ways to prevent another liquidity crisis. We say no more band-aids Bernanke, please give us a real solution. Could the Federal Reserve cut interest rates by 75bp tomorrow? Yes, but as much as the market fears that another bank on Wall Street will collapse, Bernanke fears the consequences of under delivering. Unless he wants to cause the stock market to fall by another 300 points, he will cut interest rates by 100bp and the FOMC statement will remain dovish.

The need for further monetary easing and the uncertainty in the financial markets will continue to drive the US dollar lower, particularly against the Japanese Yen. Expect 200 to 300 pip days in the majors to become the norm.

Economic data remains weak with the Empire manufacturing survey plunging to a record low and industrial production dropping by 0.5 percent. The current account deficit narrowed but the total net Treasury International Capital flow fell far short of expectations. Before the FOMC rate decision tomorrow afternoon, producer prices will be released.

About the author

Written by Kathy Lien, Chief Strategist, DailyFX



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