The surprise 75bp interest rate cut delivered by the Federal Reserve this morning brought US interest rates down to 3.50 percent, making the US dollar the third lowest yielding currency in the developed world. More specifically, US rates are now 50bp less than Eurozone and Canadian Rates, 200bp less than UK rates, 325bp less than Australian interest rates and 475bp less than New Zealand's interest rates.
The futures curve suggests that we could realistically see another 100bp of easing by the end of the year, which would put US interest rates below Switzerland's. At that point, the only currency that would yield less than the dollar would be the Japanese Yen.
As a result, we are quickly seeing the US dollar become a carry trade funding currency. A little more than 5 months ago, US interest rates were the fourth highest in the developed world and now it is the third lowest.
The last time we had an intermeeting rate cut was after 9/11 in 2001, but the last time that the Fed cut by 75bp or more was in October 1984. The big problem for the dollar is not just today's move by the Fed, but the reality that further easing will come sooner and deeper than everyone expects. It is quite possible that we may even return to 1.00 percent interest rates because the problems that the Us economy faces now is more severe than the problems it faced when the tech bubble burst (See our Instant Insight on the Fed's Emergency Rate Cut).
The combination of falling equity prices and falling interest rates was the same dynamic that sent the US dollar plunging against the Japanese Yen between 2002 and 2005. The US dollar started its downtrend in middle of 2007 and we believe that this move will take USD/JPY back towards 105 and the EUR/USD back towards 1.50.
The following chart illustrate how the dollar index moves with the rolling 12 month average Fed Funds rate.
By Kathy Lien, Chief Strategist of DailyFX.com