Yesterday was Ash Wednesday, the first day of Lent. As all good Catholics know (and do, of course), during the season of Lent, in additon to the fasting each person is supposed to abstain from something that has meaning to that individual. I'd like to extend the opportunity to abstain to the Federal Reserve Board, to abstain from cutting the Fed Funds rate further during this season of Lent.
As often happens in the market, and this one is no exception, the market has gotten way ahead of itself. This can be seen most notably in the Fed Funds futures market, where the front month contract (February) is pricing in a rate cut this month. The problem with this is that the Fed doesn't have a meeting this month, so, in effect, Fed Funds futures are pricing in an intra-meeting move, one that would occur before the expiration of the contract. (On a related topic, at some point I will elaborate on why the Fed Funds futures is basically akin to placing a bet in Vegas. Suffice it to say that futures usually for hedging or price discovery, the former doesn't generally apply and the latter shouldn't be possible as the rate is set by the Fed, a theoretically independent body. But, I digress...). It really shouldn't be difficult for the Fed to stand pat here on Funds. There is only one meeting and it's just a few days before Easter.
However, what about all of the pundits and experts crying (in some cases, literally) for more rate relief? One of the biggest cheerleaders of this movement (both figuratively and literally) was on TV this morning asking one of his guests (another reporter of the news jumping over the fence acting as an expert), "Is there no light at the end of the tunnel?" (The answer was no). If what we're in is a tunnel, the light won't be seen until we are speeding out of it at 75 MPH, only to have to slam on the breaks at the expensive toll barrier on the other side (read: rate hikes). It has been said here many times, the market needs to work out its excesses before it can move forward. A one-time selloff does not portend a new 25 year secular bull run. The technical analysis mentality that most players seem to have fallen prey to does not fit in with the larger macroeconomic problems we are experiencing.
Why should the Fed stay put? I'll list some reasons. The first should be obvious. Since mid-September, Fed Funds have already been cut 225 bps, the effect of which has yet to be felt. The marginal benefit of further cuts now is dubious. Second, and even more important than the first, is that the markets must be weaned off of its addiction to continual Fed Funds cuts. I can point to Japan as an example of where that policy didn't (and doesn't) work. Ask the "experts" why stocks are lower and the answer you will get is that there won't be Fed Funds rate cut today. The markets need a market-based solution to this problem. If that means something (s) go bankrupt to resolve things, then so be it. That is capitalism. Government can and should try to soften the blow, but at the end of the day, companies, markets, and people, etc. need to succeed or fail without being completely propped up by outside forces. My final point here, and there are many others, is that the Fed has to keep something in reserve on the Fed Funds front in case it is really needed down the road.
The Fed has done a good job at keeping the markets moving in this period of credit crisis and illiquidity. What the vast majority needs to remember is that markets need to be aable to move in both directions in order to function properly.
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You are absolutely corect that the Fed should pause both from the moral hazard standpoint and beause it takes at least six months for Fed policy to be felt.
I think the two biggest factors driving the Fed are:
1) It is an election year. Read into this all you want.
2) The banks are crying poverty.
a) They have taken tremendous writedowns and their balance sheets are hurting. They needed low-cost liquidity.
b) They have more writedowns coming both from more subprime and commercial mortgages (the next sho to drop
c) Since they have toughened their lending standards (borrowers actuallly hav eto have documented incomes and a credit check needs to be preferomed. Banks must rly on prime lending which does not have the margins associated with subprime lending. Hence, they need a steeper yield curve to make teh carry trade more profitable.
d) A monoline insurer bailout. The monoline bond insurers, besides insuring munis with high underlying credit ratings and corporate bonds with lower, but still solid investment grade ratings, insure...... CDOs!!!
That is right boys and girls, the only thing preventing further significant writedowns at the banks is that some of their CDOs ae insured. No insurance in these things could be glow in the dark with no one willing to touch them (no bids).
The banks may be the who bails out the insurers, if that means more borrowing. Lower rates will help (how they del with potentially wider credit spreads is another story).
I am actually now cheering on more easing. I am short the long bond. If the Fed keeps easing, that should keep inflation present and long-term rates should rise. I am predicting that the 30-year bond flirts with 5.00% by year end.
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