It has been an extremely volatile day in the currency markets with big figures (100 pip) moves in USD/JPY happening in a blink of an eye. The more than 4 percent decline in USD/JPY is the largest single day percentage drop in close to 10 years. The degree of the moves that we have seen today in many currency pairs is normally something we would see in a quarter or even in some cases, a year. For example, the AUD/USD plunged as much as 9 percent today while NZD/JPY dropped more than 10 percent. Given that the dollar has collapsed against the Yen but soared against the Australian dollar, Euro and British pound indicates that the story today is deleveraging and liquidation. With the Dow accelerating its decline on the break of 10,000, the only thing that can stop the fall in equities and carry trades is coordinated easing by the G7.
Fractured Responses Not Working – Time for Coordinated Easing
As we have seen by the US’ Troubled Asset Relief Program (TARP) and the deposit guarantees announced across Europe, fractured responses are not working. There is no doubt that the problems have gone global and as result, a global response is necessary in order to stop the freefall that we are seeing in the financial markets. Over the past 20 years, shifts in the stance on currencies by the Group of Seven have triggered dramatic turns in the US dollar. Although the volatility in the US dollar has become a secondary story to the weakness in the US stock market, what the G7 meetings teach us is that a coordinated message by the major central banks around the world can put a stop to hemorrhaging. G7 Finance Ministers are meeting on Friday in Washington. At this stage of the game, there is no reason for central banks to not seriously consider coordinated action. The European Central Bank hinted that they are ready to cut interest rates, the Bank of England and the Reserve Bank of Australia are expected to do so this week and Fed fund futures are pricing in a greater chance of a 75bp versus 50bp rate cut by the end of the month. It is time for the Bernanke to step up to the plate and do all that he can to stabilize the financial markets. Increasing the size of the Treasury Auction Facility and paying interest on reserves is just not enough.
Expect a Dead Cat Bounce
For both carry trades and equities, the sell-off has been nothing short of brutal. However as we have on September 30th, the day after the Dow Jones Industrial Average closed down 777 points, a dead cat bounce of a few hundred points would be natural. We have been calling for the Dow to hit 10,000 and for USD/JPY to fall to 100 for a good number of months and now that those targets have been reached, there is a decent chance that could see a bounce. Wall Street and Main Street have been frightened by the monumental moves in the stock market and when fear is at its peak, the light may be just around the corner. This is not to say that we believe that rosier times are ahead, but the hemorrhaging may soon ease. The crisis in the financial markets has become so severe that a reaction that is more significant than what we have seen so far needs to come from government officials and once there is coordinated action, we may finally see stability. Growth will remain weak however, but for the US stock market we could enter a phase of contracting ranges. After Black Monday in 1987, the Dow Jones Industrial Average range traded for 14 months.
Zero Percent Interest Rates in the US?
Given that the Japanese went to zero percent interest rates in order to pull their economy out of stagnation, one of the big questions in the markets is whether the US will do the same? Although we do not expect interest rates to fall to zero percent, current conditions in the US economy and the US financial markets are bad enough to warrant bringing interest rates back down to the 1 percent levels that we saw during Greenspan’s tenure. The financial crisis that we are facing now is certainly damaging than the burst of the technology bubble. The minimum that Bernanke needs to do is to bring interest rates down to 1.50 percent. The sell-off in commodity prices also helps to offsets the inflationary pressures of printing money, making it more feasible for the Federal Reserve to cut interest rates. For the US, lower interest rates will mean a lower currency. When Greenspan cut rates from 6.5 percent down to 1 percent, USD/JPY fell from a high of 135 to a low of 103.40. This 25 percent move represented the dollar’s shift to a funding currency. Since the Fed started cutting interest rates last August, USD/JPY is down 18 percent. If 1.00 percent becomes a reality in the US, USD/JPY could hit 95.