US GDP growth has contracted but that has not stopped the equity and currency market from rallying. The GDP number was not as bad as the market had feared but what really drove the markets higher was the Federal Reserve’s new Term Asset-Backed Securities Loan Facility (TALF).

Both the outgoing and incoming Presidents are stepping on the gas and that is helping to restore investor confidence. President Elect Barack Obama has formed his Economic Team and is outlining his Economic Stimulus plan. The Bush Administration, bailed out Citigroup yesterday and has now made a colossal announcement aimed at putting a bottom in the asset market.

Their 35% increase in the Fed balance sheet represents another $800B worth of stimulus and will cause the Fed’s balance sheet to balloon to $3 trillion. For investors that have been concerned about the funding crisis, this is an even bigger reason to sell dollars.

Here is what the Fed announced minutes before the GDP number:

- New $200B facility to support ABS
- Buy up to $500B in mortgage securities backed by Fannie Mae, Freddie Mac and Ginnie Mae
- Buy up to $100B in direct obligations of housing related Government Sponsored Enterprises
- The Treasury will use $20B of TARP funds to provide credit protection to the Fed

Expect GDP Growth to Worsen

The 0.5% drop in GDP is mild when compared to past recessions and raises the risk of a sharp decline in fourth quarter GDP. Many people believe that the current downturn is the worst since the Great Depression and if that is true, we could easily see GDP fall by 4 or 5 percent in one quarter. In 2001, GDP contracted by 1.4 percent in the third quarter. In 1990, GDP fell by 3 percent in the fourth quarter and in the first quarter of 1982 GDP dropped a whopping 6.5 percent. There is no reason why the worst case scenario this time around is just a 0.5 percent contraction in GDP.

Remember That This is a Crisis of Confidence

However despite the pessimistic outlook for growth, it is important to remember that this was a crisis of confidence. So priority number one for the outgoing and incoming Presidents is to restore confidence. Since Friday they have done a good job with that if Obama outlines more plans at his speech later this morning, we could see the rally in the currency market continue. Don’t forget that the further monetary stimulus is also in the pipeline with the Fed expected to cut interest rates again next month.

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