Forex Markets: A Look Into The Dollar, Part III

Welcome to Part III of a four part series discussing the current state of the foreign exchange markets and the future problems and issues that will surround it. Part I of this series explained the general relationship between commodities, the Euro, and the Dollar. Part II of this series discussed the reasons why the dollar has rebounded recently. This article will discuss the European and U.S. central bank’s rate cuts, their fiscal stimulus plans, and the LIBOR to fed funds rate and the affects these issues have had on the Dollar and Euro.

Rate Cuts

The U.S. has been ahead of the European Central Bank, or ECB, on this front for a number of reasons that have been plaguing the domestic economy. Fed Chief Ben Bernanke has cut the Fed’s key interest rates down from 5.25% to 1.00% over the past 18 months. The Fed also hinted that further rate cuts may be necessary to stimulate the economy and help out the financial system. Many economists are predicting that the Fed may cut another 50bps to get the rates down to 0.50% at the next meeting. Some of the reasons surrounding the Fed’s recent decisions include the current state of the nation’s banks, rapidly increasing unemployment rate, and lower GDP forecasts.

The ECB on the other hand has been relatively slow to react with their interest rate cuts. This is primarily due to the goal of the ECB, which is to fight inflationary pressures. The U.S. has three main goals that they focus on: stable prices, GDP growth, and unemployment. The U.S. determined that it was more important to fight the recessionary pressures by lowering rates, rather than worry about inflation. On the other hand, the ECB has focused on inflation and let the general markets take care of themselves. At the ECB’s last meeting, they decided to cut their interest rates by a half point from 3.75% to 3.25%. Earlier this year, the ECB actually increased their interest rates, at the same time the Fed was lowering theirs. This was because the ECB saw huge inflationary risks in the short term. Many economists are now predicting the ECB to cut their rates to below 1.5% before mid-2009 due to deflationary pressures.

A statement from ETUS, or the European Trade Unions, stated: “Interest rates need to be cut fast and deep before inflation would turn to zero.” In the same statement the ETUS chief, John Monks, said: “Europe faces the danger of a triple D-scenario: Debt reduction leading to depression, leading to deflation, and from there back to excessive debt and deleveraging.” The Eurozone’s GDP also shrank for the second consecutive time in the third quarter by 0.2%. These are the same risks that the U.S. is currently facing and the same scenario that the Japanese economy experienced in the early 1990’s.

The Euro and Pound originally gained on the U.S.’s Dollar earlier this year because of the fact that many people believed the issues the U.S. were facing would be contained for the most part. The ECB was also increasing their interest rates at the same time that the Fed was lowering theirs, this signaled to the markets that the Eurozone may have been in a better position than the U.S. and their currency should have reflected that.

LIBOR to Fed Funds Rate

First, it is important to discuss the differences between the fed funds rate and LIBOR. The fed funds rate is the target interest rate that is determined by the FOMC (Federal Open Market Committee) and is used to implement their monetary policies. LIBOR is a calculated interest rate that is set by the rate that highly credit-worthy institutions are willing to lend to each other.

The Libor to Fed Funds Rate has been a spread that has been closely monitored throughout this whole financial crisis. This spread has increased dramatically over the past year with the failure of major banks and investment banks such as Lehman Brothers (LEHMQ.PK), Washington Mutual (WAMUQ.PK), National City (NCC), Wachovia Corp. (WB), etc. The current 3 month LIBOR rate (quoted from bankrate.com) is around 2.22% today, down from 3.47% one month ago. This is currently trading at a spread of roughly 120bps above the current fed funds rate. This rate is fairly high compared to the historic spread, which is usually not more than 25-50bps. This spread of 120bps is much lower than the spreads that were seen after the bankruptcy of Lehman. During this time, many financial institutions froze their inter-bank lending because they were afraid of the counterparty risk. The Fed has been proactive about this situation implementing many new programs to try to boost confidence into the markets.

Wrap-Up

It’s now apparent that both central banks are focusing on revitalizing their respective economies and fighting off deflationary pressures. The U.S. has done a lot in regards to lowering rates, but the ECB still has a ways to go in order for it to successfully meet its monetary objectives. Monetary policy alone is not going to solve all of the problems though, and strong fiscal stimulus packages will be a necessity in the recovery of both U.S. and Eurozone economies.

Disclosure: None

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