The Fed Gives In and Gives the Market Credit

By Dr. Duru written for One-Twenty

September 19, 2007

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One day, those of us who care about Fed policy will look back on September 18, 2007 as a unique moment for for the Fed. At a time when oil is hitting all-time highs, agricultural prices are soaring, unemployment is bumping along historic lows, the dollar keeps getting crushed, the stock market (the S&P 500 and the Dow) are near all-time highs, U.S. corporations are still making near record profits, and companies from Intel to Caterpillar are proclaiming that global markets are the "hottest ever," the Fed chose to cut rates. And it did not just take a little off the top. The Fed took the financial market's most ardent pleas to heart and took a whole 50 basis point chunk out of rates. It gave the market credit in a big way. By taking such drastic action the Fed hopes " help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time." (click here for the full statement).

I earlier claimed that expectations had risen so high for Fed action that there was no way the Fed could live up to the pressure...forcing the market to fade off any post-Fed euphoric pop. Well, I'll be. The Fed caved into the pressure in almost picture-perfect form. Almost. The Fed is still claiming to be on inflation watch: "Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully." For those of us looking for a post-Fed fade, the key trick here is that the Fed has told us that it reserves the right to reverse its rate reversal at any time it sees fit. The market is now free to fear continued risks of recession in case the Fed dropped rates 50 basis points to be "one and done" and/or fear an acceleration in inflation. Regardless of the excuse, we still have some conditions in place for what I anticipated should be the fade of the year. I cannot see the market giving up the biggest pop in 5(?) years in one day, but I have a strong suspicion that we will see prices return to Tuesday's open before we get new 52-week (and all-time) highs in the market.

Despite my dour short-term opinion, I must reiterate that I remain bullish on stock market prices. Sure I completed my transformation from bear to bull within a week or so of the year's high, but I have to give the market credit and add to the mix the apparent capitulation lows that we got in August. Those lows now look like a successful retest of the lows for the year. All the institutions that have been dumping stock will feel compelled to buy. The headge funds will feel compelled to cover shorts.

Do you want further evidence that the market will be looking up more than down for a while again? Well, remember all those bad headlines about credit markets seizing, hedge funds blowing up, and credit drying up? Pooh, pooh. In the first of four brokerage earnings reports, Lehman Brothers essentially said that it is doing just fine all things considered, thank you very much:

Chairman and Chief Executive Officer Richard S. Fuld, Jr. said, “Despite challenging conditions in the markets, our results once again demonstrate the diversity and financial strength of the Lehman Brothers franchise, as well as our ability to perform across cycles. For the quarter, we reported record net revenues in Investment Management, and our second highest net revenues in both Investment Banking and Equities Capital Markets. In addition, more than half of our net revenues for the quarter came from outside the U.S...” Sure "Within Fixed Income Capital Markets, the Firm recorded very substantial valuation reductions, most significantly on leveraged loan commitments and residential mortgage-related positions," but "these losses were partially offset by large valuation gains on economic hedges and other liabilities. The result of these valuation items was a net reduction in revenues of approximately $700 million."

$700 million? Is that all? The Fed is cutting rates to save the financial powerhouses from nickel and dime losses (OK, maybe dime and quarter)? On the earnings conference call, Lehman proudly declared that its "...liquidity position is now stronger than ever." Uh, Big Ben...are you hearing this? Seems like the market has been in the process of taking care of its credit problems. We can see the building optimism in the strong run in the broker stocks for the past month. I suppose the deep rate cuts seal the deal now.

I will end by referencing good ol' Alan Greenspan. He could not have timed the publication of his book any better. On the eve of what the media was calling the Fed's most important meeting in years, we got to see Greenie all day on CNBC, effectively promoting his book and waxing poetic on the long years of his life and storied career.
Anyway, during his interview he talked about the danger of fear in the financial markets. Fear and the lack of confidence are strong corrosive materials; they cause markets to sieze up. Today's credit markets had lost faith in the various credit products peddled to market players. Too many feared holding the bag on a bunch of sub-prime and low-quality crap and chose to abstain rather than take the risk. With a little more time and a whole lot of work, the financial markets probably could have cleaned things up. But certainly Big Ben and the current Fed have chosen to cross their collective fingers on inflation and throw the market a bone. The Fed wants to see that happy-go-lucky tail wagging again. There seemed to be too little time to let the free markets work things out. So now with lower short-term rates, financial institutions are supposed to be ready to lend and buy credit again. Does a rate cut clear out the junk? Does it force more responsible lending? Does it cause a more "rational" pricing of risk? I think not on all counts. But maybe it creates emotional relief, lowers stress levels, soothes the nerves: The Fed is on the case; the Fed "knows" what's going on. The economy - markets and consumers- gets more credit. And that's all this over-leveraged economy really wanted.

Be careful out there!

© DR. DURU®, 2007