Before the US stock markets opened this morning, the Federal Reserve announced a plan to buy commercial paper directly from issuers in yet another attempt to unfreeze the credit markets. Although this led to a rally in US stocks, USD/JPY and other carry trades, the rally was short-lived. Having been up as much as 165 points intraday, the Dow Jones Industrial Average ended the US trading session down 508 points.

For the Federal Reserve and the US economy, the new commercial paper funding facility is a step in the right direction because it lends directly to business sector. However what the Fed ceases to realize is that the lack of liquidity comes from the lack of confidence and so far, their approaches have been too conservative to warrant a recovery in confidence. We have been calling for coordinated easing by central banks around the world, but the Reserve Bank of Australia has now raised the bar by cutting interest rates 100bp. In response to the turn in equity markets, Fed Chairman Ben Bernanke has finally buckled when he said that the Federal Reserve is ready to cut interest rates. Unfortunately a quarter point rate cut at this point is not enough, especially when compared to Australia’s full percentage point cut. If the Fed had surprised the markets with a 25bp rate cut last week after the House’s approval of the bailout plan, that one-two punch to the credit crisis may have done the trick, but now the Fed needs to do more if they want to put an end to the hemorrhaging that we have seen across the financial markets.

Is the Fed Waiting for the G7 Meeting?

One possible reason why the Federal Reserve has yet to cut interest rates may be because they are saving ammo for Friday’s G7 meeting. According to the comments by ECB member Quaden this morning, the Federal Reserve’s counterparts in Europe are also ready to cut interest rates. As we have seen by the Fed’s commercial paper announcement, the Bank of England’s plan to inject capital into as much as GBP 45B into banks and Spain’s EUR 50B bank rescue fund, fractured responses are not working. A signal of solidarity and coordinated interest rate cuts by central banks around the world is the minimum that the markets need in order to reverse the current trend. US stocks continue to sell off with the Dow Jones Industrial Average falling to the lowest level in 5 years. Bernanke’s comment about possibility cutting interest rates has not helped the US dollar or US equities because Investors want less talk and more action.

What to Expect for the US Dollar

The US dollar continues to behave very differently against the Japanese Yen and every other major currency. Although the dollar weakened against the Yen, it has soared the Euro, British pound and Australian dollar. In fact, year to date, the only currency that has outperformed the US dollar is the Japanese Yen. The reason for this divergence is because interest rate expectations are once again the primary drivers of currency prices. The US is expected to cut interest rates aggressively over the next 12 months, but the verdict is out on whether rates would fall as low as 1 percent. For the Eurozone, 100bp of easing has already been priced into the markets while traders are expecting 150bp of easing from the Bank of England by next October. Even the Reserve Bank of Australia is expected to cut another full percentage point. The Federal Reserve has been cutting interest rates since last August so they only have a limited amount of room to ease whereas the last move made by the European Central Bank in July was an interest rate hike. Therefore we expect the dollar to continue to fall against the Japanese Yen but strengthen against the Euro, British pound and Australian dollars.

Why Commercial Paper

For our readers who may be confused by the Fed’s action in commercial paper, it is important to understand that the commercial paper market is where companies go to raise short term money to buy inventory, meet payroll obligations and pay bills. In recent weeks the commercial paper market has been under a lot of stress due to the lack of buyers for the commercial paper, making it difficult for companies to meet their day to day obligations. The Fed’s hope is their willingness to be the buyer of last resort will help to tie these companies over and prevent bankruptcies, making investors more confident in the process.

Meanwhile the FOMC minutes revealed that the Fed was considering cutting interest rates last month. The world has changed quite a bit since September 16 and even if the minutes were hawkish, the Fed has no choice but to cut interest rates – it is not a matter of if, but a matter of when.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.