December FOMC Preview: How a 50 or 75bp Rate Cut Will Impact the Dollar

Tuesday’s FOMC meeting will be remembered for decades to come as the Federal Reserve brings interest rates down to the lowest level this generation has ever seen. With 2 realistic options on the table and economist and traders divided on how much the Fed will cut interest rates, the only certain outcome is significant volatility for the currency market. The US dollar is selling off aggressively going into the rate decision as traders realize that after tomorrow, the dollar will either be the lowest or second lowest yielding G10 currency.

No matter how you look at it, an interest rate of 0.50 percent is just as bad as an interest rate of 0.25 percent.

Federal Reserve: 50bp vs. 75bp

The decision of cutting interest rates by 50 or 75bp is really a decision of how quickly the Federal Reserve wants to formally move to Plan B, or Quantitative Easing. If rates are not taken to 0.25 percent tomorrow, then we could see that level reached in the first quarter of 2009. Fed funds contracts are currently trading at 0.15 percent, which means that any rate cut by the Fed will only be symbolic. The futures contracts are pricing in a 74 percent chance of a 75bp rate cut and a 26 percent chance of a 50bp cut, but only 11 out of the 95 economists surveyed by Bloomberg expect interest rates to be cut by more than 50bp. Either way, someone will be proved wrong tomorrow and that could trigger a big move in the US dollar.

Economic data has deteriorated significantly since the last monetary policy meeting and in our opinion, the right thing for the Fed to do is to cut interest rates by 75bp tomorrow and not delaying the inevitable. With the US economy falling into a deeper recession, rationing monetary policy stimulus now could be counterproductive. However, the Federal Reserve may not want to back themselves into a corner by taking interest rates down to 0.25 percent so quickly and therefore many economists argue that a 50bp rate cut is the most likely scenario.

Another reason why the dollar is selling off is because if the Fed eases by only 50bp, they could still signal that interest rates are headed to zero, which would also be negative for the US dollar. The only reason why the dollar could rally following the rate decision would be if the Fed signals to the market that zero interest rates is not a possibility. Unlike Japan, deflation has yet to hit the US and zero interest rates could intensify problems that the repo market and money market funds are already facing. Demand is waning in the repo market as the return is insufficient to cover the risk of failure.

FOMC Statement Needs to Answer 3 Questions

In many ways, the FOMC statement is even more important than the actual interest rate decision. There are 3 questions that the market expects the Fed to answer in the accompanying statement:

1. Are interest rates headed lower?
2. Will interest rates be taken to zero or will we see a BoJ style rate cut that takes interest rates somewhere between 0.25 percent and zero?
3. What is the plan for Quantitative Easing?

Since a full percentage point rate cut is off the table, the Federal Reserve will need to signal whether interest rates will continue to fall and by how much. Although everyone is thinking about rate cuts in quarter point clips, the Fed could take another page out of the Bank of Japan’s book and ease interest rates somewhere between 0.25 percent and zero in March. In other words, 0.15 percent could be the low in US interest rates next year instead of zero. Any hint of this possibility could have a big impact on the currency market. The FOMC statement could also include details for Quantitative Easing. For many people, QE is a new concept that has only one precedent and therefore the Fed may want to offer some transparency.

What Happens After Zero?

When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last month, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Implications of the Fed’s Rate Decision on Currencies

The weakness of the US dollar against all of the major currencies reflects the market’s expectation that after Tuesday, the US dollar could yield less than the Japanese Yen. If that comes to reality, we could see further weakness in the US dollar against all of the major currency pairs but if the Fed only cuts by 50bp, there could be a violent move in the US dollar depending upon the tone of the FOMC statement.

The following table illustrates how key pieces of US economic data has changed since the last monetary policy meeting. Although consumer confidence has improved and we are beginning to see some upside surprises in US economic data, the trend of most data still points to dollar bearishness.

Dollar Table

 

About Kathy Lien 236 Articles

Kathy Lien is an Internationally Published Author and Chief Strategist of DailyFX.com, one of the world’s most popular online websites for currency research. Her trading books include the highly acclaimed, Day Trading the Currency Market: Technical and Fundamental Strategies to Profit form Market Swings (2005, Wiley); High Probability Trading Setups for the Currency Market E-Book (2006, Investopedia); and Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game (2007, Wiley). As Chief Currency Strategist at FXCM, Kathy is responsible for providing research and analysis for DailyFX, the research arm of FXCM. She also co-edits the BK Forex Advisor, an Investopedia.com Premium Service with Boris Schlossberg – one of the few investment advisory letters focusing strictly on the 2 Trillion/day FX market.

Kathy is also one of the authors of Investopedia’s Forex Education section and has written for Tradingmarkets.com, the Asia Times Online, Stocks & Commodities Magazine, MarketWatch, ActiveTrader Magazine, Currency Trader, Futures Magazine and SFO. She is frequently quoted by Bloomberg, Reuters, the Wall street Journal, and the International Herald Tribune and has appeared on CNN, CNBC, CBS and Bloomberg Radio. She has also hosted trader chats on EliteTrader, eSignal and FXStreet, sharing her expertise in both technical and fundamental analysis.

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