A week ago, I wrote that it would be important to see if ‘the US Federal Reserve can pull a rabbit out of its hat’ at its meeting later that day. The dust has now settled on its 0.5% Fed Funds rate cut, and one can see that short term liquidity has certainly been improved, although at the cost of weakening the US dollar.
Equally, US 2 year rates today are virtually unchanged from a week ago, at 4.05%. The same is true for 5 and 10 year rates at 4.30% and 4.63% respectively. This indicates that the main effect of the Fed’s cut was only to improve liquidity in the short-term money markets. In turn, of course, this encouraged the restoration of overnight and 3 month lending between banks, and also enabled stocks to rally.
The other main impact of the cut was to weaken the US dollar. Against the euro, the dollar had been trading above 0.72 euros, but it is now below 0.71 euros. It also dropped marginally against the yen, from around 115 yen to 114 yen, even though there was a political vacuum in Japan due to Premier Abe’s surprise resignation. More surprisingly, the Canadian dollar is now trading above parity with its US cousin, for the first time in over 30 years.
This consistent pattern of US dollar weakness suggests that the Fed’s move has disturbed overseas investors. They have been financing the US deficit for some years, and so an overnight retreat into euros or yen would still seem unlikely. But Asian and Middle Eastern holders of dollar assets are clearly feeling more nervous than a week ago.
Overall, then, the Fed probably achieved its main short-term goal, of restoring liquidity to the markets. But in so doing, it has opened up new questions about its commitment to fighting inflation, and therefore caused investors to question its underlying commitment to a strong dollar.
And back in the ‘real economy’, today’s Case-Shiller index showed record US house price falls in July, even before the credit crunch hit in August. It must therefore now be time for chemical companies to start battening down the hatches, and rolling out the cost-leadership programme that we began to discuss here in early July.