Fed Day: Expect A Cut, But I Say Save The Bullets!

A: No shock here folks, the markets are expecting between 50 & 75 bps of easing to the funds rate and likely discount rate as well. If you ask me what I think the fed will do, I would say cut 1/2 point. If you ask me what I think the fed should do, I think they should only cut 1/4 point, and leave some room later on for a 50 or even 75 bps cut if things get real hairy! With quantitative easing (read Jeff's piece on September 5th, "The Path of Deleveraging: Quantitative Ease Please!") upon us and ahead of us, this rate cut is more for 'cushioning the blow' that the macro economy is about to bring. The statement also should show an increase in deterioration of economic indicators, with the bias towards economic growth leaving inflation risks aside.

The report and decision is out at the traditional 2:15PM time. With equity prices down some 45% or so from peak levels hit mid 2007, one can argue that stocks have 'priced in' a very severe recession already. S&P earnings expectations for 2009 had been cut a few times already and its pretty clear that nobody really knows how bad the hit to corporate profits is going to be; only that it will be bad! In my view, its the dragging out of declining profits and lagging earnings warnings that is the big threat to stocks over the next few quarters.

We have a 16 month credit crisis going on, and one could argue that the duration of very challenging conditions for corporations even after the credit markets normalize could last at least another 12-16 months. The damage was done and we are entering the period of damage assessment. Ugh, macro economic data (gdp, unemployment, manufacturing, etc..) for 2009 is going to be really ugly and after the first wave of it, we will start to look for things like 'the Second derivative', or a slowing of the rate of change in the deterioration. How high will unemployment hit? How fast did GDP contract? How many quarters did GDP contract? Etc..

The fed knows this and massive fiscal and monetary stimulus has been applied already to cushion the blow to the real economy as we assess damage from the 16-mth credit tsunami. The NBER already declared the recession to have started in DEC 2007, so I want to know, are we approaching mid way through, or are we past mid way through?

Anyway, it seems clear the fed is about to embark (if they haven't already) on a path of quantitative easing with the FFR so low already. For those that don't know, this basically means the fed will be printing money & increasing the money supply, likely by purchasing longer term treasury bonds from primary dealers and injecting the cash directly into the system. In fact, it seems to already be happening. This was the medicine Japan used in the '90s to fight deflation once they used up the 'bullets' of rate cuts. With our funds rate at 1%, I wonder if the fed really wants to bring that rate to 0%. I know Ben wants to inflate, and inflate he will try to do, but the effects of rate cuts on lending rates have not been having the desired effect. So to me, this rate cut is more for a 'bigger cushion' to the economic blow that is upon us. Also, the stock markets are pricing in 1/2 point cut and I doubt the fed wants to disrupt the markets right now; this is how it has become.

Since the mid '90s, I've been watching these rate decisions and the impact on the tradable markets very closely. With volatility comes trading profit potential, so as a trader, I want to play it. Its a nice side effect to have seen how markets react when they don't get what they want!

Anyway, Ben is a scholar, not a trader, and so is the rest of the fed board of governors. They will cut today, but I think it should be only a 1/4 point. If quantitative easing is the path they are on, and they know this better than we do, why waste another bullet if we don't need to? Cutting 1/4 or cutting 1/2 at this stage won't worsen the economy, so its a matter of how much additional cushion towards the present downturn they want to apply; rate cuts take 8-2 months to funnel through the economic system. Lets not forget, there is a big cushion already in place via massive easing for the past 15 months; the oomph of which still lie ahead of us.

So, save the 1/4 point for when we might need it more. This seems to be the worst crisis in the past 70 years or so, and stocks have got hit hard. However, as a trader, I can tell you that we only had 1 limit down day so far pre-open! It would be narrow sighted of me to predict no more catastrophic opens ahead of us, especially in the near term. With "Made - off's" scam revealed, how many more cockroaches may be lying underneath? What major company will issue a big profit warning? What major company may declare bankruptcy? What major fraud may pop up here or abroad; hmm that rhymes? What major bank may have to be rescued or nationalized? What may the next spark be?

Who knows. But to say this threat is beyond us, at this point in time, is silly. So, save your bullets for when we may need it most. We can always use them! But when they are gone, we can't and the markets may go through a rough phase where a 1/2 point surprise rate cut both achieves the added cushion to economic growth + calming the markets as they react to an event.

PHOTO SOURCE: Marketblog.com

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