FX Implications for 25-bps and 50 bps Fed Move

Forex Fundamental Analysis Reports | Written by CMC Markets NY | Sep 18 07 12:06 GMT |

5 reasons why the Fed should go for 25-bp cut

1. The incoming Fed easing cycle will start from 5.25%, a lower interest rate level than the beginning of previous easing cycles. Given the uncertainty of the current environment, the Fed will want to maintain its firepower for a possible deterioration in credit conditions, market/banking confidence and economic fundamentals.
2. Despite the freeze in liquidity and reduced confidence amid banks seen in rising inter-bank rates, equity markets have risen 7% from the mid August lows, indicating that the Fed's liquidity injections have partially succeeded in averting a serious dislocation in confidence and liquidity.
3. Economic data, while pointing to clear evidence of weakness (home prices/sales, construction spending, retail sales, jobless claims), the deterioration has been slow and gradual. Despite showing declines, ISM services and manufacturing remain above 50, never a coincident figure for 50-bp cuts.
4. The bigger easing alternative of 50 bps will mean a more rapid assault against the already beleaguered US dollar, which is at 15-year lows against a basket of 6 currencies, and less than 30 points away from its 36-year lows. Unlike in 1998 and 2001 when Fed rate cuts boosted the dollar, the current global economic landscape is characterized by a unique decoupling of central bank policies from that of the Federal Reserve. Even if the ECB, BoE, RBA and BoC remain on hold, a lack of easing is already a positive for their currencies against the US dollar.
5. A 25-bps rate cut in the fed funds to 5.00% is likely to be accompanied by a 50-bps cut in the discount rate to 5.25%, therefore reducing the difference between the two rates and hence, the effective penalty on banks seeking assistance at the discount window. On the other hand, a 50-bp cut in the funds rate will require a 75-bps cut in the discount rate in order to reduce the difference between the two rates and more effectively the reduce the implicit penalty of discount borrowing. Reducing the penalty of discount borrowing is important especially that banks borrowed over $7.0 billion from the discount window last week, the highest since the week of September 11
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