Not Your Average Day

September 15, 2008

Today has been one of those very few days that leave financial market observers and participants truly speechless, like September 11, 2001 and October 19, 1987 when the Dow fell 508 points of 22.6%.  The roll call of victims — Countrywide, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and Merrill Lynch — will continue to unfold in unexpected ways.  I don’t think there’s any question under the circumstances that the Fed funds rate will be cut tomorrow by at least 25 basis points.  If the cut is not by 50 bps, I expect a follow-up move before yearend to 1.5%.  These are forecasts that did not cross my mind last week.

Rates will be headed lower in other economies as well.  China eased sooner than expected today.  I’m less confident that policy at the Bank of Japan (Wednesday) and Swiss National Bank (Thursday) will be left unchanged especially since the yen and Swiss franc have strengthened.  The Swiss decision will embody where other central bankers think ECB policy is headed in the near term.  Bank of England plans to hold off further rate cuts until November also must be reconsidered.  The U.K. financial services-intensive economy is disproportionately exposed to the global credit crisis.

In any case, U.S. inflation-adjusted central bank interest rates stand out from the rest of the crowd, connoting the loosest stance.  A Fed funds rate of 1.75% set against 5.6% CPI inflation translates to negative 3.85%, while a 1.5% nominal money rate equates to a a real rate of -4.10%.  When the Fed funds rate was at a nominal 1.0% from mid-2003 to mid-2004, its lowest inflation-adjusted level was -2.1%.  The associated ECB rate floor earlier in this decade was at 2.0%, and the inflation-adjusted level during that period bottomed at -0.6%.  By comparison, the ECB refinancing rate is now at 4.25%, 0.45 percentage points above the 3.8% rate of CPI inflation.

Attributing the dollar’s rally to cyclical trends in the United States (better) and elsewhere (worse) has a major shortcoming, and that is the widening gap in the Fed’s policy stance compared to monetary policies in other economies.  In the first half of 2008, the U.S. grew faster than Europe or Japan.  There is less reason to expect that advantage to persist, and the dollar still vastly lacks interest rate appeal.  Nonetheless, the dollar has not relinquished a lot of ground against the euro, leaving one to conclude that risk aversion, not economic fundamentals, is its main support.  To the extent this is so, one cannot count on a linear dollar uptrend, because the crunch is neither linear nor predictable.  The crisis could dominate the dollar for another year or for less than three months.

Gold jumped today as one would expect but is far below its cyclical high of $1032.70, which rules gold out as a Plan A in these unsettled times.  I believe the yen will be supported with intervention if it threatens to strengthen past 100/$, so a big move in that relationship is unlikely.  I suspect the euro has more near-term scope to weaken against the dollar, but the choppiness of its daily moves and unpredictability of the flight to safety will make it a hard trend to ride.  The path of least resistance quite plausibly might be selling commodity currencies as global demand struggles, but even that strategy has counter-intuitive elements like hurricanes.  None of the options look compelling on this confusing day.  It’s true that in the worst chaos, opportunity can often be found, but it will take faith by investors to step into the unknown.  Anyway, boldness may not be a good thing, since the present mess happened because too many investors swarmed into derivatives with little understanding of their risks.



One Response to “Not Your Average Day”

  1. Jennifer says:

    Larry, impressive blog! I turned to it today as all is going crazy in the financial world, to see an economist’s view of what this means. Thanks for helping a non-financially savvy person to understand a bit of what’s going on.