Dollar Rallies, But be Wary of an Intermeeting Rate Cut

The Fed cut US interest rates by 75bp turning the US dollar into the second lowest yielding currency in the developed world. For currency traders the rally in the US dollar was expected because the Fed under delivered while the 400 point rise in equities suggests that stock traders are simply relieved that they got a big rate cut.

In the FOMC statement, the Federal Reserve was downbeat about growth but they reminded everyone that inflation is not off their radar. Producer prices indicate that even though headline inflation growth is slowing, prices on a core level are rising. We have not seen the last of rate cuts, but the FOMC statement did contain a tinge of hawkishness as two members of the FOMC voted in favor of a smaller move.

However we believe that the Federal Reserve is giving themselves the flexibility to cut between meetings if needed. Over the past month, they have made historic moves by opening up the discount window to banks and accepting investment grade debt securities as collateral. They know that the market needs time to absorb the recent moves and want to save some ammo for later if another bank sees the same fate as Bear Stearns.

This is not to say that a 75bp cut is not a big move. It is only the second time in the past decade that interest rates had been eased this aggressively. Meanwhile the futures curve is still pricing in a strong probability that interest rates will fall to 1.75 percent in June. With the fear of counterparty risk potentially triggering liquidity problems for other banks on Wall Street, the Federal Reserve is still on high alert. Despite the slightly hawkish statement, they will not be able to sit back and relax just because they have stepped up monetary easing.