As Rates Race to Zero, Printing Presses Gear Up

Antonia Oprita,
CNBC
Monday, Dec 15, 2008

When the Federal Reserve policymakers decide on interest rates Tuesday, investors will probably look one step beyond their decision, to gauge how much money will the Fed be willing to print once it is out of rate ammunition.

Rates won’t likely hit zero Tuesday, but this could be unavoidable in the near future, according to strategists and market experts.

Unemployment is likely to surge after more job cuts have been announced by banks and the U.S. auto industry teetering on the brink of collapse. The housing market is likely to take another hit as more people lose their jobs, and consumption will plummet further.

“Rates will fall close to zero. Everywhere,” Hugh Hendry, chief investment officer and partner, Eclectica, told CNBC.com. “The central banks will be forced to take them to zero because of the widespread disruption in society, for job losses.”

And nations may have to let them stay there for a long time, while finding new ways of easing policy even further.

“It’s a typical race to the bottom,” Ronald Stoeferle, equities analyst, Erste Bank, told CNBC.com. “But it’s probably too late for this. In the current situation, I think we have to wait for this whole drama to unfold.”
The drama may be prolonged and could take its toll on one of the world's most successful currencies: the euro [EUR-TN 1.369 0.0004 (+0.03%) ].

If this crisis happened 15 years ago, currencies of various countries in Europe would have depreciated and this would have mitigated some of the shock, Hendry said.

During the recent boom years, Europe was captured by private equity mania, small businesses were laden with debt, credit cards and consumer credit flourished. Now the debt must be paid and Hendry says it may take 10 years for this to be achieved.

A 10 percent to 15 percent contraction of the European economy is possible over the next 36 months and after that "we'll spend six years recouping to the GDP level of 2007," he predicted.

Without a flexible exchange rate, unemployment will surge, especially in the weaker euro zone members, the PIIGS as Hendry calls them – Portugal, Italy, Ireland, Greece and Spain – and these countries will break out of the single currency.

How Zero Rates Can Sting

The problem with massive easing is that once interest rates have hit zero there is nowhere they can go, analysts said. And rates at 0 percent can start to do damage.

Rates below 0.5 percent in the U.S. could generate losses at money market mutual funds, which charge a fixed management fee, Paul Ashworth, an analyst with Capital Economics, wrote in a research note.

In turn, outflows from these funds would have a knock-on effect on already battered credit markets, as money market funds have over $3 trillion under management and a third of that is invested in commercial paper and corporate bonds.

Redemptions will mean funds will dump these assets and forced selling could push up borrowing costs for businesses, choking them even further, Ashworth wrote.

In the UK, rates at zero may mean that savers will not feel any incentive to keep cash in long-term deposits, making it harder for banks to meet their regulatory liquidity ratios, economists from Investec said.

"What is currently more important than the price of money is the quantity of money," Investec's Philip Shaw wrote, adding that UK rates may get close to zero by the spring.

Printing Money

The Fed has already moved on from using interest rates as a monetary policy tool and the next fed funds target rate after the Dec. 16 meeting is "almost academic," ING economist Rob Carnell said.

The Fed's balance sheet has expanded to more than $2 trillion, made up of collateral received in exchange for liquidity provision, or loans of Treasurys.

"In our view, this is, for want of an alternative description, 'printing money'," Carnell wrote in his research. "And our assumption is that there is more of this to come."



Besides mortgage-backed securities and asset-backed securities, the Fed will purchase Treasurys, corporate paper and even stocks to provide much needed cash, he predicted.

"The Fed's only option is effectively to 'print money' by crediting the reserve balances held by commercial banks at the central bank," Ashworth also said.

Buying Treasurys would be the biggest weapon that hasn't been deployed yet, as such a policy means the Treasury could pump into the economy as much cash as it needs.

"There's no limit to the amount of money that the Fed can print and Congress can spend," Ashworth said.

But for some, that's a scary thought, as the amount of U.S. government debt is already staggering.

"Nobody really knows how these policies will work out," Stoeferle said. "If it were another country, the U.S. should probably declare bankruptcy."

Dollar Staggers as U.S. Unleashes Cash Flood, Deficit (Update3)

By Bo Nielsen and Daniel Kruger
Dec. 15 (Bloomberg) -- The biggest foreign-exchange strategists and investors say the best may be over for the dollar after a four-month, 24 percent rally.

The currency weakened 5.9 percent measured by the trade- weighted Dollar Index after strengthening between July and November as investors bought the greenback to flee riskier assets and repay dollar-denominated loans from lenders reining in credit. Ever since peaking on Nov. 21, the dollar fell against all 16 of the most-widely traded currencies, according to data compiled by Bloomberg.

U.S. policy makers are flooding the world with an extra $8.5 trillion through 23 different plans designed to bail out the financial system and pump up the economy. The decline shows that the increased supply of money may be overwhelming investors just as the government steps up debt sales, the trade and budget deficits grow and de-leveraging by investors slows.

“The dollar will go to new lows as the U.S. attacks its currency,” said John Taylor, chairman of New York-based FX Concepts Inc., which manages about $14.5 billion of currencies.

Citigroup Inc., Goldman Sachs Group Inc., BNP Paribas SA and Bank of America Corp. predict further weakness. Last week was the first time in almost a month that consensus estimates for the dollar against the euro through 2009 fell, according to the median forecast of 47 strategists surveyed by Bloomberg.

Taylor, whose firm manages the biggest hedge fund focusing on foreign exchange, said while the dollar may strengthen next year, it will fall to a record low against the euro in 2010 and to a 13-year low of 80 per yen as soon as 2009.

The dollar fell to 90.68 yen as of 2:11 p.m. in New York from 91.21 on Dec. 12. It declined to $1.3678 per euro and traded at $1.3703, its weakest in two months, from $1.3369.

‘Turning Point’

Speculation that the dollar has peaked gained steam last week as the currency plunged 4.9 percent against the euro to $1.3369, its biggest drop since Europe’s common currency was created in 1999. It weakened 1.75 percent versus the yen.

“We’re at a turning point in terms of dollar dynamics,” said Jens Nordvig, a New York-based strategist at Goldman Sachs, the biggest U.S. securities firm to convert to a bank. “The dollar shortage has been addressed and we’ll see people start to focus on other things and those are all dollar negative.”

After rising from $250 billion in September and October, dollar cash positions at U.S.-based banks have stayed at about $800 billion since Nov. 1, according to Nordvig.

A survey last month by New York-based Sanford C. Bernstein & Co. found that 63 percent of hedge-fund managers said they are about half done selling securities to reduce their use of borrowed money after financial companies cut back on credit following almost $1 trillion in writedowns and losses since the start of 2007. Twenty-three percent said they were three- quarters finished.

Yen Example

Goldman Sachs says the dollar may weaken to $1.45 per euro by the end of next year. Up until Dec. 11, the firm forecast that it would end 2009 at $1.30. The median estimate in a Bloomberg survey is for the currency to finish next year at $1.25.

Dollar bulls say it’s a mistake to bet against the currency now because Treasury yields are falling to record lows even as the government prepares to sell more than $1 trillion of debt, a sign there’s no end in sight to demand for the safest U.S. assets. They also say the yen, which typically rallies as risky assets decline, is appreciating.

“The yen’s strength falls into our theory that the risk- aversion trade is not off the table,” said Peter Rosenstreich, chief market analyst at Geneva-based currency trading firm ACM Advanced Currency Markets. “The fact that the yen continues to gain strength validates our theory in the longer term, the dollar safe-haven trade is not done yet.”

‘Bad News’

Robert Sinche, the head of global currency strategy at Bank of America in New York, the third-largest U.S. bank, says the dollar is bound to weaken because investors are starting to focus on traditional measures of value such as relative interest rates, budget deficits and trade balances.

As more loans are repaid, there is less need for dollars, forcing investors to value the currency on metrics such as relative interest rates, budget deficits and trade balances. By those measures, the greenback should weaken, according to Sinche.

“A lot of the reasons why the dollar went up are not sustainable and have started to disappear,” said Sinche, who predicts the currency will weaken to $1.44 per euro as early as March 31. “Bad news about the U.S. economy is beginning to be bad news for the dollar.”

Lower Rates

The Federal Reserve will cut its target rate for overnight loans between banks in half to 0.5 percent on Dec. 16, the lowest level since 1958, according to the median estimate of 84 economists in a Bloomberg survey. The European Central Bank’s target rate, currently 2.5 percent, will bottom in 2009 at 1.75 percent, according to a Bloomberg survey of economists, making the euro relatively more attractive.

Treasuries due in two years yield 1.49 percentage points less than German bunds of similar maturity, near the most since mid-October. Three-month bill rates fell below zero last week for the first time. Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., which oversees the world’s largest bond fund, said “Treasuries have some bubble characteristics.”

“The government and the Fed cannot continue to talk about trillions of dollars of financing and expansion of the Fed’s balance sheet without the dollar going south,” Gross said in a Dec. 10 interview with Bloomberg Television

Budget Deficit

Spending to shore up the financial system caused the U.S. government’s budget deficit for the first two months of fiscal 2009 that started in October to balloon to $401.6 billion, the Treasury Department said Dec. 10.

“It’s absolutely going to get worse before it gets better,” said Michael Englund, chief economist at Action Economics LLC in Boulder, Colorado. “We’re looking at a $1 trillion deficit, and that’s before the next stimulus package. If Treasury spends all of TARP, it could be $1.2 trillion to $1.3 trillion.”

The $700 billion Troubled Assets Relief Program is one of the programs set up by the government and the Fed to try to bring the economy out of the worst recession since World War II. President-elect Barack Obama also plans a stimulus package that House Speaker Nancy Pelosi said may total $500 billion to $600 billion.

The dollar’s rally may have hurt the trade balance, and earnings of companies that depend on sales overseas. U.S. exports slid to a seven-month low in October, causing the trade deficit to swell to $57.2 billion, the Commerce Department said Dec. 11. American exports dropped 2.2 percent to $151.7 billion as foreign purchases of U.S. aircraft, automobiles, chemicals and food waned. The trade gap was projected to be $53.5 billion.

Shrinking Economy

The U.S. economy may contract 3.9 percent this quarter and 2 percent in the first three months of 2009, according to the median estimate in a Bloomberg poll.

“Rapid deterioration in the U.S. economy, coupled with the adverse effects of monetary and fiscal stimuli, do not bode well for the dollar,” Citigroup strategists Todd Elmer, Michael Hart, James McCormick and Aerin Williams wrote in a report from New York on Dec. 12. The New York-based bank “foresees short- term dollar weakness, against both Group of 10 and emerging- market currencies,” they wrote.

The Citigroup strategists predicted on Nov. 6 that the euro, which was trading at $1.2715, would rally toward $1.33.

Paris-based BNP Paribas, Europe’s third-largest bank, recommends buying the euro versus the dollar amid signs that equity markets may be stabilizing. The MSCI World Index is up 16.6 percent since falling to a 5 1/2-year low on Nov. 21, the same day the Dollar Index peaked.

‘Positive Euro Bias

“With equity markets broadly stable with a positive bias and volatility easing, we expect the euro-versus-dollar declines to be capped at the $1.28” level, a team of strategists headed by Hans-Guenter Redeker in London wrote in a report Dec. 10.

Like Goldman Sachs, London-based Barclays Plc, the U.K.’s third-biggest bank, forecasts the dollar will weaken to $1.45 per euro by the end of 2009, according to data compiled by Bloomberg. New York-based Morgan Stanley strategists Stephen Jen and Spyros Andreopoulos, who in August advised clients to buy the dollar, said in a Dec. 11 report that the currency may strengthen in the first half of 2009, before “underperforming most other currencies” as the global economy recovers.

“We’re seeing that correlation between equities and the dollar break down,” said Adam Boyton, a senior currency strategist in New York at Deutsche Bank AG, the world’s biggest currency trader, according to a 2008 Euromoney Institutional Investor Plc survey. “The fact that the dollar is weakening in this environment probably tells you a bit more focus is coming back on the fundamentals of the U.S. economy.”