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The decision by the US Federal Reserve last night to cut the Federal Funds Target Rate for the first time in four years, has patched over the issue of the inter-bank liquidity but creates very real concern over inflation.

The Federal Funds Target Rate was cut from 5.25 per cent to 4.75 per cent. The cut of 50 basis points was a move away from a level that had remained unchanged since June 2006. The US Discount Rate was also cut by 50 basis points, following a previous cut of the same amount on 17 August. It now stands at 4.25 per cent.

Ryan Kneale, market analyst for BetsForTraders, said, “The cut in the Federal Funds Rate has been the talk of the markets since the US Non-Farm Payroll figures came in drastically below expectations on the 7 September. A cut of 25 basis points was expected by many but with global financial markets in disarray as a credit market liquidity freeze was taking place, the US Federal Reserve – in a bold move - cut the rate by 50 basis points. This aggressive action on the part of the Fed has been greeted warmly by global financial markets as a possible cure to the recent ills.

“This move by Ben Bernanke can be seen as pre-emptive. With such an aggressive move, the central bank is indicating that they don't want to be reactive down the track, in the event that the credit crisis deepens, with stronger negative implications for the broader economy. Rather, by being proactive, they will almost certainly free up the sticky issue of the three-month inter-bank liquidity as the LIBOR spread narrows and reduce the possibility of further bank woes, making life easier for consumers.

“On the downside, a rate cut of this magnitude has inflationary implications as it will inevitably serve to feed the consumer debt spree by keeping borrowing costs low. The issue of inflation is concerning but less so than the more immediate lack of liquidity in the credit markets. Asset specific inflation, particularly in the housing market, will be watched closely and may well dictate whether or not the market is granted another cut at the Fed's next meeting. At this stage, given the size of the cut and the immediate reaction of the markets, we feel confident that there will be no immediate follow up next month in the form of another reduction in the target rate.”

Following the Fed’s announcement last night, the impact on the markets was immediate as the US indices exploded upwards, with the Dow gaining 200 points in the three minutes immediately after the news release. Banking stocks led the gains with energy stocks close behind. Oil hit $81 a barrel, Citigroup shares were up 4.82 per cent, Morgan Stanley up 5.41 per cent and Bank of America up 3.41 per cent. The Dow finished the day up a massive 335 points (2.51 per cent) with the broader S&P closing up a colossal 43 points (2.92 per cent). In the foreign exchange markets, the US dollar suffered as a consequence of the 50 point cut, as the yield advantage held over major currencies decreased. The US dollar hit record lows against the euro, trading at 1.3986, losing 85 points in the 10 minutes after the announcement. The Pound also gained ground as it took an immediate 140 point lead against the Dollar during the same period. The Pound was left trading above 2.0140 by the end of the session, having been as low as 1.9880 during early morning trading. The bounce didn't last, however, and by the middle of Wednesday it was back down below the psychologically important level of 2, trading at 1.9987 by late morning.

Ryan continued: “The violent reaction of the foreign exchange markets implies that traders really were caught off guard by the magnitude of the Fed's Target Rate cut.

"Last night was quite an evening at HQ. After steady trading for most of the day, we were bowled over by a barrage of bets, as 64 per cent of our client base started trading simultaneously. Most are supporting the trend in the near term with 72 per cent of clients now long the US stock market and only the remaining 28 per cent betting on a reversal in the major US indices. Foreign exchange bets have dominated, with the Sterling/Dollar exchange rate being the most traded last night and into this morning. A handful of clients called it before the event and really cleaned up on the move. People expected volatility but the market moves that ensued undoubtedly surpassed our expectations.

“The question now is how long the rally lasts. Clients who think that it will persist to the end of the week are picking up some good odds just now. This implies that the bulk of clients don't believe that the rally has stamina.

“Our concern is that when the dust settles and traders have had a day or two to consider matters, they will conclude that the inflation risk is stronger than Ben Bernanke gives the economy credit for. If the market does take this view, then we expect the rally in stocks to be short-lived, with consumer companies and banks being the first to give way.

“If this happens, we still don't expect the Dollar to strengthen much, as the prospect of an about-turn by the Fed in the form of a rate rise is so slim that the dollar is probably going to remain weak for some time yet.”

The internal models, which are based on the aggregate of all client trades, show a 7 per cent chance of another cut next month, so we can all but discount that at this stage. However, the models do show a 53 per cent chance of a cut in November, and the cumulative probability of a cut before the year end stands at 81 per cent.

Ryan concluded, “Any further easing would show signs of desperation and also risk destabilising traders who, as of now, are actively taking on some chunky positions.”

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Notes to the Editor:


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