Big Fed Day: Rate Cut Likely But...

A: Ben Bernanke and Co. will decide at 2:15 EDT today what their course of action will be, if any, for monetary policy that affects the overnight lending rate banks charge each other and which sets the tone for either restrictive or stimulative policy towards the US economy. In my opinion, the stock market has already priced in a 1/4 point rate cut and future cuts into equity prices and will ultimately selloff when they don't get as aggressive a move or statement when the fed releases their decision later today. Here's why.

Here are the main reasons why the fed will only cut by a 1/4 point, if at all, and not release as aggressive a statement in regards to future rate cuts:

Inflation Risks - Oil is at record highs, Gold is over $700/ounce, and other commodities are at highly elevated levels keeping longer term inflation risks from dissolving. Alan Greenspan even went on record recently as stating that long term inflation remains a very real concern and that he worries about double digit fed funds rates at some point down the road. The fed is still stuck between a rock and a hard place and can't risk aggressively lowering the fed funds rate and pumping too much liquidity/stimulus into US economic systems and ultimately making long term inflation risks even worse.

Weak US Dollar - The US dollar will gain some strength against European currencies if the credit mess hits over there and the ECB sees a need to stop raising rates, reverse course and actually lower rates. But that is yet to be seen. The credit crunch hitting Northern Rock in the UK has told us that Europe is not immune to current risks and that they may be next. As far as strength in any currency, there will be little if the overall economy gets hit; a strong economy yields a strong currency. We know that the US dollar has been super weak and I just don't see how our fed could start to embark on a aggressive rate easing campaign, further weakening our currency. Our currency could see gains on other currencies though IF this credit contagion ends up hitting global economies which will cause central banks to lower rates and global currencies to give up some gains against the US dollar. It seems we were first in this mess and could be first out of it too.

Stocks Still Near Record Highs - Major stock indexes are only 5-6% off record highs. Does this sound like an environment ripe for major rate cuts to you? If there were no chance of a fed rate cut, stock indexes would probably be 2-3% lower! There is already a premium priced into stocks for today's expected rate cut.

Avoid Recent History - One major reason we are in this credit mess (which is the main reason for US recession fears right now) is because of ultra cheap money and Greenspan's aggressive action on monetary policy bringing the fed funds rate down to 1%, keeping them there for too long, and not raising them back up aggressively enough (2 years of 1/4 point rate hikes is as slow a course of action as you can get). How could Bernanke and Co. ignore the risks of recent history repeating itself by aggressively lowering fed funds rate again; they can't and won't!

There are also real reasons for the fed to take action knowing that any fed move today will not effect the overall economy for a good 8-12 months. A few of these reasons include the very weak jobs report that came out a few Friday's ago, the nation wide housing problem, illiquidity in credit markets (which a cut in discount window can help a bit), and expected side effects to US economy and consumer spending. Some argue the fed is already behind the curve and about 2-3 rate cuts too late, while others argue that inflation fears are far too real to warrant any move in the fed funds rate. Very tough position for Ben Bernanke and his colleagues.

Here is my call. The fed will:

1. Cut Fed Funds Target Rate 1/4 Point (25 basis points)
2. Cut Discount Window 1/2 Point (50 basis points)
3. Issue a more conservative statement than most expect and mention they will be 'ready to act' as needed and determined by incoming data. Mention that inflation risks still remain in some way, shape or form.

I think the stock markets will ultimately selloff on the move after pricing in this action already. I do NOT think the fed is about to embark on a long term rate easing campaign! I think they will cut rates by a total of 50-75 basis points at most, bringing the fed funds target rate down to 4.5% or so, as a preventative measure to cushion any economic slowdown that does result from the credit/liquidity crunch. Not only that, but it is very likely that we won't stay at those levels for long, as inflation risks will force the fed to raise rates more aggressively down the road (a longer term view of fed funds target rate).

If I'm wrong, and the fed doesn't cut the target rate today by 1/4 point, I think the move will be NO CUT AT ALL! I think those expecting a 1/2 point rate cut are way off, and I will be very surprised and worried if that happens. Here is what to expect for all scenarios and my percentage bet for each:

65%: Fed Cuts Target Rate 1/4 Point + Discount Window Cut ---> Initial jump in stocks and then selloff
30%: Fed Doesn't Cut Target Rate + Discount Window Cut ---> Stocks selloff
5%: Fed Cuts Target Rate 1/2 Point + Discount Window Cut ---> Stocks rally

All in all, a very important day to see where our monetary setting body stands right now and for future moves that may be in the works.

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