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FOMC Decision And The Markets
I'm going to divide this post into two sections. In the first, i'll discuss the background and provide some trading scenarios in the second. There is likely to be a fairly predictable short term market reaction however, the ultimate direction of global equity markets and currency prices (and therefore the global economy as a whole) will be determined in the interbank (LIBOR) market because LIBOR is the real key to global liquidity. [B]BACKGROUND[/B] In order to understand what this means, you need a brief introduction to LIBOR. LIBOR is a daily reference rate at which banks offer to lend unsecured funds (in a specific currency) to other banks in the London wholesale money market (or interbank market). LIBOR provides rates for banks lending in Sterling, Dollars, Euros, Yen, Swiss Francs, Canadian dollars, Australian Dollars, Swedish Krona, Danish Krone and New Zealand dollars. Rates for a wide variety of debt instruments (including currencies) are set from LIBOR. Right now, LIBOR's for Sterling, Euros and Dollars are well above central bank target rates. Three month Sterling LIBOR is 6.75% (down from a high of 6.90%) while the overnight rate has risen to to 6.47%. As long as central bank expectaions remain constant, LIBOR spends most of its time around 15 basis points above official central bank overnight rates, meaning that Sterling LIBOR is around 85 basis points higher then where it would be under normal circumstances. This is essentially where the re-pricing of credit has occured and where the vital signs of global liquidity can be taken. The sub prime and U.S. housing situations were the catylists for the spreading of fear to the ABCP market and this (along with things like Northern Rock) led to the upside re-pricing of LIBOR. It's the fear of what assets such as CDO's, CLO's, Conduits and SIV's are now worth. It's the fear about what the losses will be and the fear about who exactly holds what. It's a guessing game regarding who will be the next Northern Rock. If you're interested in knowing whether the fed's move will have the intended effect of easing the global liquidity squeeze-this is where to look. Because so many financial instruments (including currencies) are priced here, if LIBOR's do not ease the global liquidity situation will not improve. It is by no means definate that the fed's target rate reduction will have an immediate effect on LIBOR. What we can say is that so far, all of the world's central bank actions to this point have not eased the situation to an appreciable degree and that the Northern Rock incident has increased overnight LIBOR for Sterling. In one sense you can view the situation as if The Fed, BoE and ECB had all raised their overnight rates. You could also draw the conclusion that central banks do not at this time have the same degree of influence in the interbank market that they had prior to the liquidity crisis. It's a very unstable and dangerous situation that unquestionably will lead to a global recession if not corrected because high interest rates have the effect of slowing growth and because real interest rates have risen into slowing U.S. job and housing markets. It's really as simple as that. [B]TRADING[/B] In all likelihood, the 25 basis point reduction is a done deal and it's likely that another move will be made in the discount rate. All eyes will therefore be on the statement and what it implies, however, in my opinion a dovish or hawkish statement are both equally dangerous to the global economy right now. A hawkish statement basically means that the fed is confident that the economy will continue to grow, but will no doubt cause equity markets to sell off strongly in part because there is a 50% chance of a 50 basis point cut currently priced in. In that case GBP/JPY will depreciate as the Dollar gains vs the Pound (and the other high yielders) and dives vs the Yen. Besides being bad for the equity markets, you can also basically forget about LIBOR (and by proxy, global liquidity) easing anytime soon. In this situation, LIBOR and equities can only improve if and when those markets agree with the fed's outlook on growth and that's not likely to occur until a whole lot more economic data points in that direction, especially with jobs trending down to an anemic 1.2% YoY and housing starts off over 40% from the January 2006 peak. A dovish statement will no doubt give a short term boost to equity markets, meaning that GBP/JPY will appreciate as the Dollar dives vs the Pound (and the other high yielders) and gains on the Yen, but a dovish statement is risky on at least four levels: 1. A weak dollar is inflationary. 2. As the dollar weakens, foreigners may be less inclined to fund the current accout by purchasing U.S. debt. We might become dependent on Japan to take up any slack that occurs. 3. Oil will go to $100/bbl within weeks, if not days. 4. Once the euphoria dies, markets will come to the conclusion that growth looks to be getting weaker going forward which obviously will not help equities or liquidity. [B]CONCLUSION[/B] It's perfect timing that Alan Greenspan has released his book and is giving interviews, because what the markets need right now is a strong dose of Greenspan's "Fed Speak". It's essential that the Fed not remain transparent about its future moves at this time while repeating assurances that it stands ready to provide liquidity. What also must happen is what always happens in times of squeezed liquidity: banks must be persuaded to lower rates and agree to lend. In this case, the banks involved (British Bankers Association) are those involved in the interbank market, because it is those banks who set LIBOR. Thanks for reading my post and please use the box on the left to vote. If you're interested in finding out about my trade room, blog and trading primer contact [email][email protected][/email]
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