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No, ZIRP is not one of the “Fantastic Four” super heroes that appeared in the 2007 movie, “Rise of the Silver Surfer.”  However, ZIRP has the potential to be even more powerful than the combined capabilities of the Human Torch, The Thing, The Invisible Woman and even Mr. Fantastic. ZIRP is the acronym that stands for “zero interest rate policy.” As the global economy continues to deteriorate, economists are predicting that benchmark interest rates among the Group of Seven central banks will be cut on a wholesale basis and eventually may approach or be at zero percent. Even though the Federal Open Market Committee lowered interest rates by 75 to 100 basis points to a range of zero to 25 basis points at their December 16th meeting, it may not be enough to quickly revive the U.S. economy.   This would not be the first time that a zero interest rate policy was employed in an effort to jump start a slumping economy.  In an effort to fight the problem of deflation in a stagnating Japanese economy, the Bank of Japan used the ZIRP strategy from 2001 to 2006.  Desperate times call for desperate measures.

There is much talk now that the U.S. could be facing the same problem that plagued Japan’s economy several years earlier. It was only last July that the main fear that the Federal Reserve had was the threat of rampant and potentially uncontrollable inflation. As is usually the case, inflation usually becomes less of a concern when an economy starts to contract, which is the case now.

Currently there is even some talk of the possibility of deflation. How ironic that only a few months later the fear now is that the continuing economic malaise in the U.S. may not merely just produce the tolerable disinflation, but it actually could be spawning a very much unwanted and damaging period of deflation. As commodity prices, from crude oil to base metals and even some precious metals precipitously drop in value, the need for an extremely more accommodative Fed becomes more apparent and urgent. The deflation problem in Japan several years ago and the brewing deflation concern in the U.S. both have their roots in losses in real estate investments. One money manager said banks are only “one third to one half through their credit related write downs.” Currently there are some estimates that global write downs as a result of losses in the credit markets could be as high as $1.3 trillion due to write downs and credit losses on home loans and mortgage-backed securities.

Federal Reserve Board Chairman Bernanke said additional accommodation may have only a limited impact on the economy in the near term. He also said that the U.S. economy has been in a recession since December 2007 and "even if the functioning of financial markets continues to improve, economic conditions will probably remain weak for a time."


U.S. ECONOMY REMAINS UNDER PRESSURE

We are seeing more signs that the current period of economic weakness will continue into 2009 and may be the most severe in the last 25 years or more. The November factory orders report showed a 4.6% decline when a 2.3% drop was forecast.  This is a clear signal that businesses are scaling back on investments as the economy continues to weaken. This is the largest drop since records were first kept in 1992.The National Association of Realtors said their index of pending home resales dropped 4% to 82.3, which is the lowest level since the series was first started in 2001. The median guess for this report called for only a 1% decline.  This report is widely thought to be a leading indicator of the housing industry because it reflects signed contracts as opposed to the existing family home sales report, which is tabulated and reported one to two months later.  

The employment situation remains a concern as well. The jobless rate in November increased to 14 year high of 6.7%. Currently it is estimated that the unemployment rate for December, which will be reported on January 9th will rise to 7%. The nonfarm payroll portion of this report is anticipated to show a 510,000 increase. So far this year it is estimated that over 1.2 million positions have been eliminated. Some analysts are predicting that the jobless rate could advance to 8% or higher later this year.

The corporate earnings outlook appears to be deteriorating as well. We are hearing reports that analysts are revising down their estimates for first and second quarter 2009 earnings reports.  

According to the Commerce Department, third quarter GDP contracted by .3% and a recent survey of economists said U.S. GDP could shrink by .8% in the fourth quarter. Keep in mind that two successive quarters of negative GDP growth is the classic definition of a recession.


OVERSEAS ECONOMIES DETERIORATING  

It is becoming more obvious that the credit problems that originated in the U.S. have more severely impacted the European economy on a relative basis compared to the U.S.   Economic reports in the euro zone and U.K. continue to show further deterioration. It is widely expected that the European Central Bank and the Bank of England’s Monetary Policy Committee will continue to lower their benchmark interest rates. The reasons for a likely further easing of credit by the European central banks are the same reasons for the recent and drastic interest rate cuts from the Federal Reserve. They are also attempting to address the problems of a slowing economy and more recently the threat of deflation. It was not that long ago that the European Central Bank, the Bank of England, the Federal Reserve, along with other major central banks, lowered interest rates in a coordinated effort. At that time the U.S. central bank cited “weakening economic activity and a reduction in inflationary pressures.”  

There are continuing signs of a faltering Asian economy, as well. In order to address this situation the Bank of Japan lowered their key interest rate by 20 basis points to 30 basis points. Recent accommodation from the Bank of Japan was the first official policy change from Japan’s central bank in seven years. Japan’s economy is clearly weakening as GDP and manufacturing numbers have taken the economy into recession. It is not only the U.S. economy that is in dire need of lower interest rates. The rest of the world needs the same financial elixir; more accommodation.  Although the Federal Reserve has effectively implemented a ZIRP (zero interest rate policy), it would only be applicable to the interbank community relating to the reserves that banks are required to maintain that they lend to one another. Their customers would not be able to take full advantage of a zero interest rate policy. They would still have to pay some interest rate, although it would be at a very low level, especially for the most creditworthy borrowers.     

All of the fundamentals that have taken interest rates lower and have supported the credit markets since September of 2007 are likely to remain well into the first quarter of 2009.  We continue to have collateral damage from the subprime mortgage related financial firms’ write downs. In addition, there are few signs that the slowdown in the U.S. economy is coming to an end in spite of what appears to be an almost endless stream of bailout packages and tax cut proposals. It appears very likely that extremely low interest rates or even zero interest rate policies from the Group of Seven central banks are going to be with us for quite a while.


HIGHER FUTURES PRICES ARE LIKELY

I have received many questions lately pertaining to upside price objectives for the interest rate futures. My analysis tends to focus on timing objectives rather than on price objectives when a major market move is taking place. However, once our timing objective has been met, whatever the level of Treasury futures is at that particular time, will be the upside price objective. Expect higher prices for the entire credit market complex through most of the first quarter of 2009. Continue to trade Treasuries, especially at the short end of the curve, from the long side as the pressure on the Federal Reserve intensifies to maintain an ultra low interest rate structure.

If you would like more information on this article, please contact Alan at alan.bush@archerfinancials.com or 1.800.243.2649.

Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. The views and opinions expressed in this letter are those of the author and do not reflect the views of ADM Investor Services, Inc. or its staff.  The information provided is designed to assist in your analysis and evaluation of the futures and options markets.  However, any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to ADMIS. Copyright © ADM Investor Services, Inc.