Will the Federal Reserve Drive Interest Rates to 1%?

February 12, 2008

Believe it or not the US economy is in a recession and the Fed will need to continue to ease interest rates to prevent things from becoming worse..

How low will interest rates fall in the US? 2.00 percent? 1.00 percent?

Since the middle of last year, the US Federal Reserve cut interest rates by 225bp, turning the US dollar from a currency that everyone wanted to buy into a currency that everyone wants to sell. However despite all of the Fed’s efforts, the US economy continues to deteriorate. Most of our peers on the street believe that the Federal Reserve will stop cutting interest rates when they reach 2.50 percent level, but weakening economic data indicates that there is a decent chance the Fed will go as low as 1 percent.

When it comes to the direction of currencies, only one thing really matters and that’s interest rates. In a world where money can be transferred with just a click of a mouse, the country that offers the highest yield with the smallest amount of the risk will be the biggest recipient of foreign capital. US interest rates are now 400bp less than Australian interest rates,175bp less than UK rates and 100bp less than Eurozone and Canadian interest rates. If the Fed continues to drive rates down to 1 percent, who will want to buy dollars?.

How Quickly Will the Fed Stop?

2.00 percent. That’s my call. At this point hoping that the Fed will stop at 2.50 percent, which is only 50bp away from current levels is unrealistic. Did you take a look at the Non-farm payrolls and service sector ISM numbers? For the first time in FOUR years, there were more jobs lost than gained in the US economy. I wish I lived in Switzerland or New Zealand where the unemployment rates are 2.6 and 3.5 percent (the US’ unemployment rate is 4.9 percent). Also, the service sector which accounts for 90 percent of the US economy contracted for the first time in over four years. This is bad, very bad, which is why another 50bp will not be enough. Long term yields are stubbornly high and if they want them to come down to levels that will offer relief to borrowers with adjustable rate mortgages, they need to do more.

I think the Fed will be forced to do more than that. 2% won’t cut it, especially now that everyone is tightening their lending requirements cheap money won’t be enough. We’ll need to practically give it away to get things going again. Remember the Fed’s biggest concern isn’t price stability - its asset stability. They are deathly afraid that the 10 million US house owners holding ARMS will turn upside down on their mortgages (owing the bank more money than the house is worth) and will simply walk away from their payments. Jingle mail anyone? The Fed needs all those people to stay put, otherwise US starts to look like Flint Michigan in the movie “Roger and Me.”

No way. The last time interest rates were taken down to 1 percent was in 2003 and back then, oil prices were at $35 a barrel. They are now practically triple that. So inflation is a completely different animal this time around and for that reason, they will stop at 2 percent. Yes, oil prices are coming down, but they are still at much higher levels than 4 years ago. Also, they need time to allow the recent rate cuts to have their effect on the US economy. Once we dip below 3 percent, buyers should return to the housing market.

Oil Shmoil. I remember last time crude went to the stratosphere in the 1970’s-1980’s everyone was certain that it will trade $100-$150/bbl for the rest of our lives. Meanwhile, by late 1990’s a barrel of crude was changing hands at $12 bucks a pop. Did we have less cars on the road? Less houses? Less factories? Hardly. Laws of supply and demand came into play. No doubt we have China, India Brazil and even Russia as demand players in the market now, but as global economic slowdown hits everyone oil prices will cave. There is at least $20/bbl of speculative froth built into the commodity and once all those hedge funds start getting a margin call price will come in and inflation will be farthest thing on anyone’s mind.

I also expect the Fed to slow down. Although another half point cut is possible, Bernanke has already proven to us that he is ahead of the curve. We are not coming off double digit interest rates or even high single digit rates for that matter, which means that Bernanke does not have to deliver the aggressive easing that we saw under former Federal Reserve Governor Volcker.

Helicopter Ben? A hawk? Please…. The man wrote the manual on how to flood the system with easy money. In fact this was his main academic insight into the flaws of monetary policy during the Great Depression. Look, he has already surprised once by cutting 50bp in September. There is no reason why he can’t surprise. Yes 75bp is an unusually large cut, but its just a matter of now or later. US rates have to come down or we’ll be looking at 1970’s style disaster. We may not have double digit rates but we have Texas sized, no make that California sized problems in the finance sector – and need I remind you that many more of us work in finance than in the 1980’s. In fact 40% of the S&P is finance related. Face it, in a post-industrial economy we shuffle around money and the Fed needs to make sure we can continue to do so,

What Does This Mean for the US Dollar?

Well first, I don’t think the Fed cares about the US dollar. In fact, they probably want it to weaken.

The Fed made a calculated decision that they are going to err on the side of economic stimulus rather than price pressures I think they are betting that prices will naturally decline – especially energy costs –as economy slows down. As far as the dollar, they think that even with the weak dollar foreigners will continue to plow capital into the US. And so far they’ve been right. TICS printed at 149 Billion recently – far more than our -63 Billion Trade deficit leaving us plenty of wiggle room. Furthermore, if US slows down the rest of the world will have to cut rates as well so the interest rate disadvantage may not be as dire as everyone thinks. Still rates go as low as I think, the buck will be the Rodney Dangerfield of the currency world ( some already think that it is). Basically, it’s a “Merrill Lynch” bet – are you bullish on America? Well, are you punk? Sorry…. I started to channel Clint Eastwood there for a second. Bottom line right now I am not, so I agree with you the greenback weakens further.

Just because the Fed cuts interest rates does not mean that the weakness in the dollar will be broad based. I think the dollar will sell off the most against the Australian dollar. Can you believe that the Reserve Bank of Australia actually raised interest rates to 7 percent? I know that inflation is a big problem, but they are really putting themselves out there because growth could slow down at any moment and there recent rate cut makes it even more difficult for Australia to sustain their current pace of growth. I also like the Swiss Franc and Euro against the dollar, but I actually expect the greenback to strengthen against the Canadian dollar and British pound.

I agree on the Caddie. It is vulnerable on two fronts – oil coming off the highs and the utter dependence of its economy on US trade. Not so sure about the British pound. No doubt the UK is the quintessential hedge fund economy – 50% of all jobs came from the finance sector – and if the global credit crunch continues, no doubt BOE will have to cut rates just like the Fed. But so far data from UK has been relatively stable. Housing values have decline for sure, but other gauges like manufacturing and services are comfortably in expansion zone. That is why the BOE may only cut by 25 bp and remain stationary for a while and if they do the pound should bounce back to the 2.00 level.

Relatively stable? I think not. The UK is going through what the US went through last year. Have you seen the recent housing market and manufacturing numbers? They are just beginning to slow and like the US, housing has been the primary engine of growth in the UK over the past few years. It’s only a matter of time before the economy crumbles. If they want to shelter the economy from a recession, they need to lower rates and lower them soon.

What Does this Mean for My Stock Positions?

We have all heard the story about IBM and how 6 percent of their 10 percent revenue growth was due to favorable currency fluctuations. I am sure that they are not the only company to benefit from the weaker dollar. Multinationals or US companies that do a lot of business abroad should see strong profits in the fourth quarter – so that’s what I’ll be buying.

Bottom line, the greenback look like it will be weak for at least the first half of 2008. That means multi-nationals like Mikey D’s and Mister Softeee should continue to benefit. One idea to consider - the yen has appreciated tremendously against the dollar in the past 4 months. If US rates decline it may go to 100. Toyota – which has been flying high - from both healthy US sales and favorable exchange rates, may now see those dynamics reverse. Already we saw car sales plunge in January and Toyota was not immune. With the yen trading at 105 versus 120 just 7 months ago the future may look much bleaker for Japanese car makers, so long term puts may be in order.

Posted in Fed Rate Cut, Fed Rate Cut Expectations, Federal Reserve, Interest rates, US Dollar