Federal Reserve Needs to Continue to Cut Interest Rates (page 1 of 2)

DailyFX Fundamentals 03-26-08

By Kathy Lien, Chief Strategist of DailyFX.com

Euro Breaks 1.58, Is the Next Stop 1.60?

The Euro broke 1.58 against the US dollar today, leaving many traders wondering whether the next stop will be 1.60. Economic data out of the Eurozone continues to beat expectations while data from the US consistently falls short. As we predicted in yesterday's Daily Fundamentals, German business confidence improved in the month of March. Once again, analysts had underestimated the resilience of German corporations even though the rise in the flash estimates for the service and manufacturing sector PMI reports should have given them a clue that business activity accelerated. In fact, German businesses have not been this confident in 7 months. Eurozone industrial new orders also increased strongly in the month of January, adding fuel to the rally in the EUR/USD. The market completely ignored the sharp deterioration in the Eurozone current account balance which was the only thing that would have been impacted by the strength of the Euro. Just from an economic data perspective, the EUR/USD has a good chance of testing 1.60. Meanwhile, the big story of the day was French President Sarkozy's call for the UK to join forces with them to pressure the US into strengthening the dollar. That is nothing but wishful thinking considering that the US would never bow to the pressure of France or the UK at a time when they need a weak dollar to boost exports. Although Trichet noted that excessive volatility in the currency market is undesirable for growth, he also added that there is "no need to change framework due to market turmoil." In other words, inflation is still a big problem and for that reason intervention is off the table for the ECB. Earlier this month, we had said that the ECB would not consider verbal intervention until the EUR/USD broke 1.60. In 2004, the last time the central bank become extremely worried about the movements in the Euro, the currency had rallied 13 percent in 2 months. If we count 1.59 as the record high in the Euro, the currency pair has only appreciated 10 percent over the last 2 months. A 13 percent move would put the EUR/USD at 1.62.

Federal Reserve Needs to Continue to Cut Interest Rates

The Federal Reserve needs to continue to cut interest rates because the US economy is struggling to stay afloat. Durable goods plunged 1.7 percent last month with sales excluding autos dropping 2.6 percent. New home sales also fell to a 13 year low with average prices declining from $250,800 to $244,100. Unlike existing homes which were supported by the sale of foreclosures, lower prices failed to help the sale of new homes. Not only are we already seeing a decline in consumer spending, but with housing market valuations continuing to fall, consumers may feel an even bigger pinch in their pocketbooks. Fed fund futures have moved back to pricing in a fifty-fifty chance of a 25 or 50bp rate cut next month. The volatility of rate cut expectations have made them increasingly unreliable. If economic data continues to deteriorate, the Federal Reserve will naturally have to lean towards a larger rate cut. Barry Ritholtz posted a fascinating chart in his blog today about discount window borrowing courtesy of Bill King. In the past 28 years, there has been only 4 major jumps in the amount of borrowing by financial institutions at the Fed's discount window. The first was the Continental Illinois bailout in the 1980s, the second was the Savings and Loan Crisis, the third was 9/11 and the fourth is the current credit crisis.