Saving the Day (And Not Much Else)

Last month we wrote about the market's psychological desire for a messianic figure to swoop in and save the day amid a non-existent credit crisis:

No Credit Messiah Necessary, 8/6/2007
https://marketminder/commentary/commentarypage.aspx?articleID={8B250E6C-88AA-4DFB-B141-307AA6FD1427}§ionID=\commentary\daily

So, it was of genuine concern to see today's top financial headline:

'Hallelujah' the Fed Swoops In
By Alexandra Twin, CNNMoney.com
https://money.cnn.com/2007/09/18/markets/markets_0445/index.htm?postversion=2007091817

Yes, the markets got their religion today in the form of a balding-bearded-messiah named Bernanke. But excuse us if we hesitate to pronounce the Second Coming.

Today the Fed cut its Fed funds target interest rate by 0.5% to 4.75%. Though the magnitude was mildly surprising, a cut was widely expected by Wall Street. Stock markets surged in response with the S&P 500 closing 2.9% higher—marking the biggest one day gain in the index since March 2003.

Markets sure do seem happy today, but we suspect this was a bit of an overreaction to the upside, and wonder about the medium- to long-term effects of the move. (Read the Fed's full statement here: https://money.cnn.com/2007/09/18/news/economy/fed_statement/index.htm?postversion=2007091814)

Bernanke has made it clear the Fed will act "as needed to foster price stability and sustainable economic growth." We've said it before: The implicit message "we'll bail you out if you get in trouble" is poor economic policy. If the government proclaims there is no consequence to risky behavior, a basic functionality of capital markets is undermined and could potentially create the unintended consequence of even riskier behavior down the line.

That said, we doubt this bigger-than-expected cut will disrupt the economy much fundamentally and continue to view the Fed's recent moves, particularly in light of today's statement, as more psychologically significant than fundamental. See our past commentary:

Small Cuts Don't Much Matter, 9/14/2007
https://marketminder/commentary/CommentaryPage.aspx?articleID={8D0D5D3A-BA9C-49AF-B87A-887ACF49BDA2}§ionID=\commentary\daily

And while the Fed today acknowledged tightening credit conditions could intensify the housing correction and restrain growth, it framed the cut as a tactic to forestall future financial market "disruptions." This indicates not a new rate-cutting cycle, but instead a one-time acknowledgement of current market turbulence. It's impossible to predict, but let's hope the Fed sticks to that mantra.

Outside of curing the market's psychic discord, the Fed's move is somewhat vexing for a few reasons.

Lower short rates make virtually no meaningful difference in the short term—the effects of a rate cut won't take effect for six months to a year. And why should we care anyway since the Fed already lowered its discount rate in support of truly distressed financial institutions? Especially since very few even took them up on the offer! Even distressed mortgage lender Countrywide was able to obtain financing through lines of credit and an opportunistic investment by BofA. See our past commentary:

The Fed's Talisman, 8/17/2007
https://marketminder/commentary/commentarypage.aspx?articleID={FA91481A-B811-4DBE-A658-E4B188A07EBC}§ionID=\commentary\daily

Additionally, banks' long-term propensity to lend is virtually unchanged as a result of the Fed's move. Yes, the US yield curve has steepened, but only because the short end of the curve came down. 10-year Treasury yields are still sitting at about 4.5%. Banks are no more willing to make a 30-year loan today than yesterday. So how the Fed's move has any significant healing effect on subprime, mortgage rates, or long-term lending in general is a mystery to us.

Perhaps the most ponderous part of today's action is the Fed's persistent hawkish tone—attempting to remain cognizant of continued inflation risks while at the same time cutting a rate that will undoubtedly increase the availability of money! It's true Bernanke's statement moderated its tenor on inflation from "sustained" pressures to "some inflation risk" remaining, but just a few months ago the world feared a liquidity glut with huge inflationary implications. While MarketMinder agrees inflation fears were overwrought this year, we see few compelling reasons to whipsaw the outlook and become aggressively accommodative again. Sure, things are a bit tougher, but credit markets have lately acted very orderly:

Best Credit Crunch Ever! 8/23/2007
https://marketminder/commentary/commentarypage.aspx?articleID={2A9CDC21-2231-43ED-97E3-9A1879B76EC1}§ionID=\commentary\daily

Just as confusing is the decision to cut 0.5% instead of 0.25%. If this move was truly a symbolic acknowledgement of market "turbulence," why not simply make the 0.25% cut? The fed funds effective rate was sitting this morning at around 5.0%, making the new target rate of 4.75% only 0.25% less than the effective rate. So in context even the 0.5% cut is still not a big one.

But should the Fed somehow decide to continue cutting, there's a real possibility of a monetary policy error leading to the high inflation folks feared to begin with. While we view that as a very unlikely circumstance at the moment, the risk today is greater than it was.

Puzzling as it seems, the Fed's attempt to save the day from faux credit woes is in reality not significant enough either way to alter our view. We continue to see a strong global economy and remain very bullish on stocks.