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FOMC - Implications

The FOMC cut the Fed Funds rate today by 50 bps to 5.00% and have maintained an "easing" bias. This is the 3rd 50bp rate cut this year. The next FOMC meeting is May 15th (2hrs 45mins ahead of the RBNZ's May 16th announcement)

What about the chances of an intra-meeting cut? In my opinion this is reasonably likely. Greenspan has adjusted Fed Funds intra-meeting twice in the last 2 1/2 years (the last time was the January 3 cut), so it is clear that he is not bound by meeting dates.

The fact that the next meeting is not until May 15th adds weight to this view. The real question is, what would drive Greenspan to cut rates? I'd say he would be more likely to cut on deteriorating economic news rather than falling stockmarkets - unless it was a sudden crash on Wall Street.

A deterioration in confidence, new orders, employment or NAPM would be more likely to lead to a rate cut that an orderly and steady decline in stock prices. As long as stock prices don't fall so low such that they undermine wealth, spending and confidence, I think Greenspan is happy to see the equity bubble deflate slowly. Greenspan has said that there is "excess productive capacity" but "that this excess could continue for some time". In other words, inflation isn't the concern. Growth is the issue hare, and "in these circumstances, when the economic situation could be evolving rapidly, the Federal Reserve will need to monitor developments closely".

What does this mean for markets? Stocks: Strangely, the stock market initially rallied on the news. However it has peeled off since, which seems more consistent with the market's prior expectation of a 75bp cut. The stock market is likely to continue to be disappointed by Greenspan. As suggested above, I believe he is happy to see the equity bubble deflated slowly, and is not likely to cut just to satiate the stock market. The yield curve indicates that the Fed will keep cutting rates, but probably not as quickly as the stock market hopes for.

So, we're back to trading stocks on fundamentals - and they will likely keep falling on the back of soft economic news and disappointing earnings announcements and falling earnings expectations. Expect disgruntled longs to continue to sell rallies. Buy on dips is dead and buried.

Bonds: The bond market has rallied smalls since the rate cut and should remain well bid on the back of (1) stock market weakness, (2) a potential intra-meeting rate cut, and (3) likely soft inflation news tomorrow.

This is a very, very supportive environment for bonds, particularly at the 2-3 year part of the curve, which can continue to rally in anticipation of rate cuts. Fed Funds futures are pricing FF at 4.47% in June and 4.30% in September - or only another 50bp cut in May and another 25bps thereafter. That's not an aggressive call by the futures market by any means.

The NZD: The NZD is up smalls on the news, largely because US markets in general are disappointed by the news. However I would caution over getting too bullish NZD - the fact that the Fed appear to be on guard to cut rates again will likely keep USD sentiment upbeat. Indeed, Greenspan looks very much like the proactive central banker when compared to Duisenberg. And if the EUR remains under pressure, expect the NZD to feel it too. Note too that the Australian government's decision on the Shell acquisition of Woodside Petroleum is due tomorrow. It looks increasing likely that this deal will be declined, which could see the AUD suffer.

What does this mean for NZ monetary policy? Brash has made it clear that he is prepared to cut on the back of continued softness in the global economy. This still looks to be the environment we are operating within. In that respect, this rate cut keeps the odds on the Brash will cut by 50bps in May 16th (assuming the Fed cut by at least that up to and including May 15th). Brash has also said (press briefing following last week's MPS) that the simple fact that other central banks are easing means that the RBNZ would be more inclined to ease. If the RBNZ did not follow, cash rate spreads would widen, which is a sort of "relative" tightening in policy.

However the key message is that the relatively stronger NZ economy will see Brash responding later, and by less. The RBNZ will be easing, but not as quickly. There is an alternative and less bullish view than the "Fed will cut, and thus the RBNZ will follow" to be told. A reasonably solid argument can be made that if the Fed and RBA are sufficiently proactive that they stem the collapse in the US and Australian economies, then the RBNZ will be less likely to ease.

The idea is, Fed and RBA cuts will reduce the odds that the US and Australian economies experience sustained downturns. In other words, Brash can rely on Greenspan and Macfarlane to solve his "international problem" for him. And given the international outlook is the key risk to NZ, it may make the RBNZ less inclined to ease as quickly as otherwise.

However we believe this dynamic is more likely to limit the total extent of easings, rather than lessen the scope for near-term easings.

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