The big risk for the Federal Reserve in lowering the fed funds rate to support the stock market is the probability of another major speculative attack against the US dollar, thereby lifting commodity prices and inflation higher. The last time the Fed began a rate cutting cycle in 2001, the central bank was accompanied by a concerted easing campaign in Australia, Canada, Europe, and Korea, while the Bank of Japan stepped up its monthly purchases of government bonds. But this time around, the Fed would stand alone in cutting interest rates, and can only hope that foreign central banks won’t go through with their plans to further tighten their monetary policies. The European Central Bank won’t be joining the Fed in lowering interest rates next month, because it’s concerned about the explosive growth of the Euro M3 money supply, which threatens higher inflation. The Euro M3 money supply was expanding at a 10.9% annualized rate in June, it’s fastest in 24-years, and calls for much higher ECB interest rates to restrain its growth.
Even after witnessing a 10% correction in the European stock markets, the ECB maintained a hawkish stance, and said its monetary policy was too easy. “Given the favorable development of the Euro zone economy as a whole, monetary policy is still tending towards being expansively orientated after the last interest rate move to 4.00 percent,” the ECB said on August 20th. “The Euro’s higher exchange rate has hardly changed this economic picture up to now,” the Bundesbank added. The ECB actually welcomed the brutal correction in the European stock markets, which punished highly leveraged “yen carry” traders by knocking the Euro from a record high of 168.50-yen in July to as low as 150-yen last week. “This adjustment to a different risk landscape represents, in principle, a welcome normalization, though it happened very abruptly,” the central bank said, adding that “there had been over-corrections in some market segments.” Just three weeks ago, the ECB chief Jean “Tricky” Trichet said, “Strong vigilance is of the essence to insure that risks to price stability over the medium term do not materialize,” signaling a quarter-point rate hike to 4.25% at the upcoming September meeting. However, Trichet kept his options open. “The financial markets deserve attention, monitoring of shifts of market sentiment and we will continue to observe and will continue to have great attention to markets in the period to come.”
Yet a week later, the ECB, in an unprecedented move, pumped 94.8 billion euros ($130 billion) in the European money markets to ease a credit crunch after BNP Paribas halted withdrawals from three hedge funds because the French bank couldn’t value its holdings. “For some of the securities (US sub prime loans) there are just no prices,” said Alain Papiasse, head of BNP Paribas's asset management division. “As there are no prices, we can't calculate the value of the funds.'” In light of the recent turmoil among several German banks and France’s Bank Paribas, the odds are that the ECB will postpone its planned rate hike next month, and will wait for a later date to rein in the growth of the Euro money supply. Still, amid expectations of Fed rate cuts in the months ahead, the spread between the six-month US $ Libor and Euro Libor deposits rates have narrowed by 30 basis points in August to a difference of just 70 basis points, the lowest in 2-½ years.
Over the longer term, interest rate differentials have played a key role in determining exchange rates. Since the ECB began its rate hike campaign in December 2005, the US dollar’s interest rate advantage over the Euro has narrowed from 240 basis points to as low as 70 basis points today. Thus, the Fed can only afford a small rate cut to bail out Wall Street bankers who hold toxic sub-prime debt and avoid tipping the dollar into a free-fall. But that might not be enough to prevent a housing led recession in the months ahead.
Right now, European banks are afraid to lend money to each other without knowing how much exposure each one has to toxic sub-prime US mortgage debt. Earlier this month, the Bundesbank was forced to arrange a bailout for Germany’s IKB bank, which owns $24.5 billion of sub-prime US home loans, to prevent the biggest banking crisis in Germany in more than 75-years. German banks have been forced to raise their Libor deposit rates to attract cash from tight fisted peers, who are wary of lending to banks that might face big losses. Euro Libor futures for Sept tumbled to 95.43 in Frankfurt, lifting the implied yield to 4.57%, above the 4.40% rate that would be expected in normal circumstances. With German banks wrestling to break free of liquidity bottlenecks, the ECB lent 40 billion euros to 146 banks for 3-months to restore some stability. The ZKA banking committee, which represents the full spectrum of German banks, said “Even given the uncertain situation in the financial markets, the stability of the German banking system is not in question. There will be no long-term ill effects on inter-bank lending from tensions in the money market and the European Central Bank's provision of extra liquidity has eliminated temporary bottlenecks.”
Since copper is traded in US dollars on international markets, the red metal has mostly tracked the Euro’s value against the US dollar. Copper futures at the London Metal Exchange have jumped almost 8% to $7,260 per ton since the Fed lowered its discount rate last Friday. Thus, Fed rate cuts combined with a steady ECB monetary policy would be welcomed by base metal miners around the globe. Gary Dorsch © 2007 Gary Dorsch
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