Expect A Preventative Fed Rate Cut
A: Tough tough call here but something I must discuss as there is now statistical evidence that the US economy is slowing (read "Jobs Weaken Big Time...") amidst the turmoil in the credit markets. However, and its a BIG HOWEVER, there are still reasons NOT to cut rates that I will get into here. What will the fed do on September 18th, which will prove to be one of the biggest and most important fed meetings of 2007? I'm putting my bets on a 1/4 point rate cut, (25 basis points) PLUS another cut in the discount window, as preventative medicine to cushion the severity of any slowdown that is to come. Your thoughts?
First, let me explain why a fed rate cut will NOT necessarily mean a drastic reduction in lending rates! Right now, we are living in a new world. A world that is in the process of re-pricing risk as investors determine what type of risk demands higher premiums and what type of risk doesn't. In this new world, LENDING RISK is demanding higher premiums because quite simply it is filled with uncertainty and backed by a secondary market that is now illiquid and void of buyers. This is the simplest way for me to explain what is otherwise a very complex situation. For more in depth on this topic, read:
* How Mortgage Backed Securities Work
* Wells Fargo Rates Jump To 8% Overnight
* RMBS Markets Explained
* It's A Risky New World / Credit Spreads
Now, while lending risk is running under it's own set of guidelines, there has been a disconnect between the relationship it has with bond yields; specifically the 10YR bond yield. Recall in my AUGUST 4th post about the risky new world where I clearly stated:
Relating this to the mortgage markets, while short and medium term US gov't treasury yields are falling fast due to a flight to quality as stock prices fall, the rates on mortgage products are NOT falling at the same pace! This is because mortgage debt is now MORE RISKY than treasury bond notes and therefore demands a HIGHER RISK PREMIUM to gather investors; i.e. higher yields.
Take a look at the chart on the right which is not the most accurate for NYC lending rates but is good enough to prove the point I just made. Notice how the relationship between 10YR Bond Yields & 30YR Fixed up until the end of July (marked with two 'X's and a line on each chart where the disconnect begins) had similar movements. Then something happened! RISK! Subprime defaults hit wall street and the secondary mortgage markets ceased up. The resulting uncertainty hit stocks hard and caused bond yields to FALL (as investors fled to quality of US gov't treasury's), while the increased risk in mortgage markets ROSE (causing lenders to raise rates on loans, tighten standards, and limit options of loan products to consumers)!
Again, this is the simplest way for me to explain what is going on! So, in this new world what does the fed do? Well, there are two ways to think about it.
REASONS TO CUT RATES
* Inflation Moderating - Yea, but US metrics have been argued to be flawed. Commodity & Energy prices still very high. Inflation threats still persist. Arguments on both sides here.
* Prevent Recession - Cushioning move in monetary policy to help soften the hit when/if it comes
* Housing - Housing is still awful across much of the nation but we are yet to see a trickle effect in consumer spending. We are seeing effects in jobs now. Will fed be pro-active and cut ahead of the curve in anticipation of a slowdown in consumer spending as a result of housing downturn?
* Jobs Slowdown Three Months Now - Statistical evidence and the most compelling to warrant a rate cut. August jobs data was outright awful and the prior two months were revised down. This means the slowdown is in place already and fed is behind the curve.
REASONS NOT TO CUT RATES
* Moral Hazard - Fed bailout may prompt risky bets in future
* Weak US Dollar - Cutting rates will further weaken our currency? There are some arguments for the flip side though.
* Stocks Expect It & Priced In - Stock Indexes are only slightly off record highs as they priced in a rate cut. The fed should NOT give the markets what they want for fear they will selloff if they don't get what they want. In other words, the fed should NOT do what wall street expects. If we get no rate cut, we get a selloff!
* More Stimulus = More Inflation Risks - Cutting rates and pumping umph into the economic system could cause inflation to re-ignite down the road and energy prices to rise even further.
* Globalization Cushions Recession - Strong global economies could help cushion the downturn by itself. It may help corporate America, but the consumer is a whole new issue!
* Inflation Still A Risk - Sure, it is moderating at home, but how long will it last with oil at record highs and commodity prices still high! At some point will this re-ignite?
Cutting the fed funds target rate will NOT immediately turn around housing woes. It will NOT solve the illiquidity in credit markets and secondary mortgage markets. It will NOT solve problems with buyouts that fail to close. It will NOT solve the debt problems we have. It will NOT cause lending rates or the all-important LIBOR rate (to which adjustable mortgages/credit cards are tied to) to reverse course significantly!
You can see how tough a call this is for our fed and why this meeting is so important! The accompanying statement is just as important as the fed action is because it will tell us more what the fed is thinking in terms of future actions and their thoughts on the economy in general.
MY CALL - The fed will cut 1/4 point and bring fed funds target rate to 5%. Stocks will rally slightly as they really want a 1/2 point rate cut. I think the fed will also cut discount window again by 1/2 point to help liquidity in banking system a bit. If it's not 1/4 point, I'm betting on NO cut at all. The 1/2 point rate cut option is my least expected option. I would break it down like this:
60% CHANCE ---> 1/4 point cut
30% CHANCE ---> NO CUT
10% CHANCE ---> 1/2 point cut
Questions I have are how this will effect lending rates and the LIBOR rate, if at all. Since lending rates are operating under a different set of rules now, it's naive of us to think that past relationships between fed rate cuts and lending rates will prove true this time around!
YOUR THOUGHTS? WILL THE FED --->
1. CUT RATES 1/4 POINT
2. CUT RATES 1/2 POINT
3. NO CUT AT ALL
??????????????
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Comments (6)
I think they will cut 1/4 to feel it out. As for the divergence of mortgage rates from the 10 yr bond, doesn't the risk become acceptable after a certain point with the fed cutting?
Posted by spaceboy | September 12, 2007 6:39 PM
Great question spaceboy..I dont think so, especially if carnage in lending world continues, foreclosures continue, secondary markets are still ceased up, and there are no buyers of these mortgage backed securities.
Fed cutting funds target rate will NOT resolve the liquidity squeeze in these markets NOR decrease the risk that lenders see in near term environment by holding or making these loans.
Cutting the target rate will simply cushion the blow to the economy down the road. Cutting discount window will have more effect on adding liquidity to banking system but even that effect is limited. As long as secondary market remains ceased up & delinquencies rise, lenders will see risk in these loans and that means higher rates.
Posted by Noah | September 12, 2007 9:16 PM
no cut, if anything possible raise later:
1) low rates are the cause of the current pain.
2) inflation is lurking, and china, as the source of cheap goods which have kept inflation in check, is currently being racked by it.
3) bernanke, paulson, et al, continue to re-iterate that the economy is sound and problems are from bad lending, which lower rates would only increase.
4) the fed already helping by adding liquidity through repurchases to help the credit markets.
5) moral hazard, as usual.
my two cents: if the market expects a cut, then it would price it in. if it's already priced in, and this is all we got out of it, then a cut doesn't look like the answer - get short!
Posted by jw | September 13, 2007 10:47 AM
JW - you make some very valid arguments there. The market DOES expect a cut and a rate cut IS PRICED in already. If it doesnt happen, expect a selloff even as that means the fed believes the US economy is not in as bad shape as some economists think.
I agree with many of your points, and probably should UP my probability of NO CUT to 40-50% or so, with the rest going to a 1/4 point cut.
No chance of 1/2 point cut, but if that happens I would be seriously concerned about US economy slipping into recession.
Posted by Noah | September 13, 2007 3:18 PM
There are actually exchange traded contracts that tell you the exact market estimated probability of a fed move. You can find them on the CME website or on Bloomberg. Currently, there is a 60% chance of a 1/4 point cut, 30% of a 1/2 point cut and 10% chance of no cut. Your estimates were pretty close.
Posted by Shrav | September 15, 2007 12:00 AM
Shrav - yea I know of the fed futures contracts but I dont follow those at all. They are wrong way too often. Recall in late 2006 when they 100% predicted a rate cut by March 2007. No way the fed could cut then due to inflation fears.
They were way off. But this time, I'll buy into a 1/4 pt cut in target rate 1/2 pt cut in discount window, with a chance of no cut and a 1/2 pt cut in discount window.
I doubt they will cut target rate 1/2 pt!
Posted by Noah | September 15, 2007 9:09 AM