Will The Fed Surprise The Markets And Push The Dollar Higher?

Just How Weak is the US Economy?

But, just how weak is the US economy? According to the gloom and doom of the dollar bears, the  blow up of the housing sector and the concomitant debt losses that have ensued, threaten to push the US economy into the biggest financial crisis since the Great Depression. The housing situation is clearly dire. The latest Existing Home Sales and New Home Sales reports printed far worse than the already pessimistic forecasts as the deleveraging in housing continues. Major players in the financial sector such as Merrill Lynch and Citibank have already booked more $100 Billion in write-offs on housing bets gone wrong. Before the crisis is over some analysts estimate that more than $500 Billion in losses will be incurred severely impairing US economic growth in 2008.

Housing however, comprises only 4.5% of the US GDP and in order to get a more complete picture of economic affairs we need to examine other sectors of the US economy. As the table below shows, the health of the US economy is poor but not terminal. The labor markets are weaker but continue to generate jobs albeit at anemic pace. Consumer spending has slowed, but incomes and surprisingly enough confidence are   slightly up and while the service sector is weaker, manufacturing on balance remains positive.





Overall, while the report card for the US economy hardly looks like a straight A performance, it does not show any failing grades. In short, US economy remains in positive growth with the data signaling a slowdown rather than a full blow recession. More importantly, inflation continues to be a nagging problem with PCE Core readings above 2% while CPI headline data remains at a very high level of 4.1%.
 
Markets Forecast 50bp Cut

Given these conditions will the Fed lower rates by another 50bp this Wednesday?  The fed funds futures markets as well as analysts’ consensus certainly believe it will. The futures markets are assigning an 86% probability of a 50bp cut by US monetary officials. With traders almost universally expecting such a large move, anything less would be a disappointment especially to the equity markets. Yet with the Fed having already lowered rates by 75bp another 50bp cut would bring the total reduction in the Fed funds rate to 125bp in just one month – a remarkably dovish policy move in an economic environment that despite the obvious problems, remains expansionary.



Will The Fed Surprise The Markets?

Perhaps the bears are correct, and the state of the US financial system is so precarious that it will require such drastic action from the Fed. However, having already come under serious criticism for pandering to the markets in the midst of last week’s pandemonium sell-off which was partially caused the unwinding of fraudulent trades at French investment bank Societe General,  Fed officials  may want to reassert their authority by surprising the market with only a 25bp cut. Such a move while no doubt  creating short term volatility in the equity market would allow US policy makers more flexibility to lower rates in the future.  It may also prove supportive to the dollar which once again appears to be headed for a test of record lows against the euro.

Last week’s action by the Fed created an interest differential in favor of the euro for the first time since 2004. A cut of another 50bp would increase the spread between the currencies to 100bp. With EZ rates likely to remain unchanged at least through the first half of 2008, such a large differential could push the pair above the 1.5000 level as traders flock to the higher yielding euro.  Therefore, given the elevated pricing pressures in the US economy and the already significant amount of easing enacted this month, the Fed may choose to conserve its arsenal and lower rates only by 25bp. If it does not, and cuts rates by 50bp, the dollar could see further selling in the days ahead.