US Interest Rate Cuts and the Falling US Dollar

Back in July, I made a prediction that the US dollar will continue to devalue against other currencies. 2 months later to today, with the collapsing home lending market and the cut in the Federal Reserve interest rates by 0.5% to 4.75%. It seems that my predictions are coming to fruition (sorry, Sacha) with the USD coming to historical 30 year low against the CAD, which will likely bring the CAD to USD parity in the coming months. The USD is also at a historic low against the Euro and things do not look bright for the US economy.

With the easing of interest rates and the hopes of preventing drying liquidity in the markets, the Federal Reserve has opted to reduce interest rates to ease the pressure of businesses operating on loans. This may make it easier for the general public to borrow money which might stimulate the economy.

Tactics such as this is incredibly dangerous, as increasing the money supply leads to inflation and further devaluation of the US currency when the fundamentals of the economy have not changed, especially when it comes to looking at the US trade deficit. What I believe the Federal Reserve is doing, is reducing interest rates to keep the financial institutions that borrowed money for sub-prime loans afloat. This, may in turn slightly reduce the interest rates people further down the borrowing chain (ie. the mortgage borrowers) pay.

My opinion on this matter is that rate cuts will only buy time for the US economy from a recession unless something incredibly good happens within the economy. The primary problem the US faces is the number of people that took on mortgages, adjustable rate mortgage loans (ARM loans) in particular, while were not in the position to manage the repayment of these loans. The contracts these people signed, included a significant interest rate increase after a grace period of a few years, which drastically increased their monthly payments to unmanageable levels.

The Federal Reserve rate cut will allow these financial institutions that made these bad loans in the hopes of big profits to hang on for a while longer while they reorganize and find other markets to invest in. Unfortunately, I believe that the largest damage done is to the sub-prime mortgage borrowers that have or will be financially ruined, resulting in a tightening money supply of disposable spending leading to reduced business for other companies.

Though I cannot substantiate my arguments more concretely with statistical loan data, my opinion is that the US dollar will continue to fall and we have not seen it's value bottom out yet. I believe that the US economy will continue to deteriorate until US local manufacturing and production improves to reduce their trade deficit. I would continue to advise that people with US denominated portfolios look towards investment markets denominated in the CAD, EURO or other currencies to prevent loss financial loss from USD erosion. For stability, I would look to Europe, for growth I would look to Asia and the emerging markets.