Ben Bernanke goes fishing – part 1

I have often written that the only advantage of old age is experience and that has surely been of benefit to my readers in the first couple of weeks this year. This morning the Fed announced a 75 basis point cut in the overnight Fed Funds rate to 3.50%. It was almost 24 years ago when the Fed last changed the Funds rate in between meetings of the FOMC and 27 years ago the change was 75 bp. I have vivid memories of late 70’s/early 80’s when market interest rates would change 50bp in a few hours. It is often said that history repeats itself…but I add “not when you are expecting.” It is painfully obvious to everyone in the financial markets that the Fed is following the stock market and not leading as we witnessed under the Greenspan era.

The past, present and future

It’s important to review the past to understand the present situation and forecast the future of the economy and interest rates. 2007 saw the Fed misread signals of impending weakness from the housing sector and then compounded their mistake by announcing the weakness would not spread to other parts of the economy. The interest rate market bought into Fed talk taking the 10-year to a high of 5.26% on June 12th. With the US stock market using every decline to fuel the next advance to new highs the Fed became confident that they were meeting their dual mandate of a strong economy and low inflation. As we wrote numerous times last year, the 2nd half of the year would begin to see a bleeding through of housing problems into the mortgage security area. This Fed has used the stock market as its barometer of economic health and with new highs reached in October the Fed saw it continued its policy of slow declines in the Funds rate.

The Fed should have been watching the yen/dollar rate as it would have been given advance notice that something was terribly wrong in financial markets. The yen was used for a massive “carry trade” for hedge funds and other institutional investors who were able to borrow in Japan at rates under 1% and invest the proceeds in higher yielding instruments and currencies that included the US stock market. The key indication that something had changed occurred in mid-October when the US stock market rallied to new highs but the Japanese yen came nowhere near its lows for the year.

By the end of last year the US stock market was holding on by a thread with the hope that the first few weeks of the new year would bring new investors and capital like had happened almost every year. Friday January 4th was a sea change for almost all worldwide markets with an employment report that clearly showed a slowing in the most important part of the economy. If you lose your job it’s doubtful you will be able to spend at the rate you did when you were employed. The refinance boom in home mortgages ended last year as lenders found the originate to distribute model was broken and couldn’t be fixed. Jumbo rates rose to much higher levels than conforming (417M) and lending became more difficult for all but the most credit worthy borrowers. Needing liquidity and fearful the economy had entered a recession investors ran for the exits and stock markets fell hard with the deepest declines occurring the last two days. The Fed was caught flat footed and had no choice but to take action this morning. Next week’s FOMC meeting should see no further action by the Fed unless the US stock market continues its steep fall another 5%. It’s doubtful we saw a strong intermediate low today but it was a good first step toward the slowing of the decline and a better bottom should be seen after the jobs number on Friday February 1st.

Can the Fed catch the big fish?

Today’s cut in the Funds rate by 75 basis points is similar to a fisherman adding a few poles and changing bait in his attempt to land the big one. The key to a growing economy is credit and its availability to borrowers. Price (interest rates) is irrelevant if lenders can’t expand their balance sheet due to having too much “junk” that they had to take back from their originate to distribute model. The Fed has only one tool (short term interest rates) that can influence economic activity and has no idea if they need to lower the funds rate to 3%, 2% or 1% or even 0.01% (Japan). They can only hope and pray that corporate borrowers will want to grow and expand their businesses enough to need credit. The fear level at the Fed will increase with every Funds rate cut that does NOT stimulate demand from borrowers……..

What’s ahead for 2008 is in part 2 to be published on Thursday, January 24th.