Tuesday, December 16, 2008

Making a Turn towards Inflation

No doubt, many of you saw that the Federal Reserve lowered its target rate to record lows in a range between 0 and 0.25%. The stock market seemed to applaud the news, but there is a side effect to this action, inflation.

The value of the dollar slumped significantly. According to Bloomberg, the dollar lost quite a bit of ground to foreign currencies today.

USD-Euro down 2.5%
USD-Yen down 1.8%
USD- Pound down 1.8%

Since Nov. 23rd the Dollar has lost 11% against the Euro. Since Nov. 4th, the Dollar has also lost 11%, and nearly 20% since August.

From my casual analysis, trends in the relative value of currencies is simple. When interest rates in Country X are higher than in Country Y, the currency in Country X tends to appreciate. I have only analyzed comparisons between the U.S., U.K., and the Euro region, so this relationship may not be so simple around the world.

Another piece of related news, Jean-Claude Trichet, who is the Europe’s equivalent to Ben Bernanke, was analyzed and quoted in a Bloomberg article:

European Central Bank President Jean- Claude Trichet said there’s a limit to how far the bank can cut interest rates and signaled policy makers may pause in January.

“Do we have a feeling there is a limit to the decrease in rates? At this stage certainly yes,” Trichet told journalists in Frankfurt late yesterday.
Currently, the ECB (European Central Bank) has set its rate target at 2.5%. This is well above America’s 0-0.25%. This bodes poorly for the dollar against the Euro. It also bodes poorly for our recent spate of low oil/gasoline prices, as I have been pretty well convinced of the correlation between the dollar movements and the price of oil.

Less impressive, but still worth noting, is the spread between TIPS and Treasuries. The five year differential jumped from a session low of -0.9 to close at -0.64. Not a huge change, but a sign that deflation fears were somewhat abated by today’s Fed move.

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