The Fed Will Be Forced to Cut...and THEN What?

By Dr. Duru written for One-Twenty

September 10, 2007


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So the jobs numbers on Friday came in ugly, and suddenly the market no longer has the guts to climb up the proverbial "wall of worry." I have always loved that saying because it is absolute nonsense that only gets referenced when it works. When the market actually goes down on bad news, the wall suddenly looks insurmountable, and no one mentions it. We now hear incessant speculation of a recession. Many of those who called an 8% correction from the S&P500's all-time highs an amazing buying opportunity are now seriously considering joining the large number of institutions who have been spending the last two months or so readily selling stock. (Again, just check in on the institutional selling statistics for your favorite stocks. Stats are available on Yahoo!Finance). Nevermind that at its worst, the market merely dipped to the lows seen earlier in March of this year.

We find ourselves at an odd juncture where the market is still riding high but emotions are running low. A lot of people are moaning and groaning as if the stock market is behaving similarly to the painful swoons we experienced in 2001, 2002, and even 2003. More and more people are trying to get ahead of the increasing likelihood of economic malaise. Unlike the top in 2000, the last time the S&P was around these levels, we don't have rampant, "irrational exuberance," we seem to be teetering on a (credit) panic. The homebuilder stocks have been sinking like stones since the bounce from the 2006 lows failed in February, 2007. Also, the stocks of many retailers have been sinking all year. The signs are spreading of weakness in the domestic economy. Under these conditions, the Fed will be compelled to start cutting rates again or risk an all-out revolt on Wall Street. To wit, 2-year Treasury bills have been drop-kicked to 3.9%, and the Fed futures market is predicting cuts in rates for the rest of the year to around 4.5% by December (subtract the futures number from 100 to get the implied rate).

When the Fed meets on September 18th and begins cutting rates, the market should respond with a rally. However, this sharp rally will probably result in one of the largest fades of the year. Why do I say this? Well, I have my suspicions:
  1. The market did not rally on the poor jobs numbers which all but assured us of Fed rate cuts. Lower rates are supposed to be good for equities, so bad news should have been good (yeah, climbing the wall of worry). But fears of economic malaise overwhelmed otherwise bullish sentiments.
  2. Similarly, the market is expecting a rate-cutting campaign because it sees economic weakness ahead. If the market believed that these cuts would do the trick, the stock market would be rallying ahead of these cuts. Yes, we have bounced hard from August's bottom, but the persistent chop of near 2% up and down days exposes the market's tentativeness and anxiety.
  3. Just a month ago, the Fed was still talking tough on inflation. The Fed will be loathe and reluctant to admit so soon that they may be wrong about the strength of the economy. If I am correct on that, then the Fed will attempt to "ease" its way into looser monetary policy. This kind of slow motion action will cause the impatient market to fear that the Fed is at best behind the curve and at worst clueless.
  4. Simialrly, expectations are rising rapidly about what the Fed will do. I am hearing hopes for a surprise cut BEFORE the September 18 meeting or a 50 basis point reduction at the meeting. Folks were disappointed that the Fed did not cut last month. The higher expectations go, the less likely it is the Fed will meet them, and the more likely an instant rally from the announcement of rate cuts will be met with fresh and heavy selling.
Ultimately, the market will do what it needs to do to make Fed rate cuts a foregone conclusion. Let's hope a massive sell-off is not in the cards to get the job done. But it sure is possible. The unfortunate side-effect to these cuts will be the acceleration of inflation pressures in the economy. We may not see the inflation while folks are worrying about recession, but as the economy steadies itself, the housing crisis subsides, and retailers begin to improve, we will find ourselves awash in even more debt, increasing interest payments, and a global economy as red-hot as ever. The Fed will likely cross its fingers and hope that inflation remains tame, but it will have little control over the booming economies that surround the globe that are leading to stock markets that are performing much better than the financial markets here in the U.S.

Be careful out there!

DR. DURU®, 2007