FOMC: Going to Zero in December

Overview: Economic data over the past week confirm that the US economy is deteriorating rapidly. The culmination came with Friday's employment report showing the worst shedding of jobs in a single month since December 1974 (see Flash Comment - USA: awful employment report ). We are currently going through the darkest path of the recession and we believe that the Fed will react to the extremely downbeat data received over the past week. Consequently we have adjusted our Fed forecast and now expect it to take the Fed funds target rate to zero at its December meeting next week. The direct effect on the fed funds rate from such a cut would be limited, as it is already trading below the target rate. However, taking the tar-get rate to zero would send a signal to markets that the Fed is living up to its commitment to "...take what-ever steps are necessary to support the recovery of the economy".

The Federal Reserve has already shown a willingness to take unconventional steps in an effort to unfreeze the financial system and stop economic activity from imploding and deflation taking hold of the economy. In reality the Fed has already implemented quantitative easing and will be expanding its balance sheet further, printing money to buy longer term government and agency debt in the market. The Fed has mentioned 4.5% as a target for the 30-year conventional mortgage lending rate, and the next step could be to announce a target for longer-dated treasury yields as well. Another approach is to provide liquidity directly to certain financial markets as was done by the commercial paper programme. Bottom line is that even though the Fed funds rate is going to zero, the Fed still has several instruments left in its toolkit to push 'real economy' interest rates lower; and it doesn't appear reluctant to use them.

Market impact: Markets are currently pricing a relatively low probability of the Fed lowering the target rate to zero at its December 16 meeting. In addition, markets are expecting the Fed to raise interest rates as early as summer 2009, while we expect the Fed funds rate to remain at zero well into 2009. Hence, in the short term we see scope for a reversal of the backup in 2-year treasury yields seen since Friday afternoon and expect yields to trade closer to 0.75% in the coming month. In addition, if the Fed chooses to communi-cate a target for longer-dated treasury bonds or commit to hold the Fed funds rate at zero for some speci-fied period, that would mean a decline in longer-term yields as well.

Danske Bank
http://www.danskebank.com/danskeresearch

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