Would You Rather Have a Interest Rate Cut or a Strong Economy?

By: Hans_Wagner

Many investors seeking to beat the market are expecting a Federal Funds rate cut on September 18, 2007 as the Fed Funds Futures market is predicting at least a 25 basis point decrease. Also, it is likely that the rate cut has already been factored into the stock market. Recently, instead of focusing on the strength of the economy and the level of inflation, investors have become so enthralled with a rate cut that they are acting irrationally. When there is good economic news the market goes down. On the other hand the market goes up when the news is considered bad for the economy.

Investors need to consider whether they would rather have, a rate cut along with an economy in a recession or a strong economy with low inflation?

The economy is giving off mixed signals. Recently the government reported that the Gross Domestic Product grew at 4% in the second quarter 2007. Then on Thursday September 5, 2007 Atlanta Fed President Dennis Lockhart, who isn't a voting member of the Open Market Committee, “said that while the economic outlook is now less assured, there's still no clear sign that the misery in the U.S. housing sector is taking a significant tool on the rest of the economy.” Continuing, he said, “Weakening home prices, less available credit, and higher interest rates could cause a slowdown in home equity withdrawal for consumption.”

On Friday, September 7, 2007 the Labor Department reported that nonfarm payrolls fell by an estimated 4,000 in August 2007. This is the first decline since August 2003. Wall Street economists had expected an 115,000 increase, so this is a significant surprise. An interest observation is the minimum wage was increased on July 24, 2007 from $5.15 to %.85 and the largest drop in the payrolls was teenage workers. Maybe this is just a coincidence or maybe this caused much of the drop. Just keep in mind that this report is subject to substantial revision, so we could see a move up at a later date. In any case this report added to the expectation that the Federal Reserve needs to lower rates at or before its next meeting.

The credit markets beyond the mortgage business are facing a much tougher time. According to Thompson Financial leveraged buyouts in August were at the lowest level in two years. Leveraged buyouts rely on bank loans to finance their deals. The banks are taking a more careful look at their risk exposure to these deals, since they are facing a much more difficult time selling off participation in these loans to other institutions and investors. Also high yield bond activity fell to its lowest level since 1991.

Corporations are facing an extension of the credit crises as the market for commercial paper has become much more restrictive, especially firms with less than excellent credit. According to Federal Reserve reports the level of commercial paper has decreased by $243 billion, an 11 percent drop. This is one of the reasons the Fed has lowered the Discount Rate to encourage banks to help shore up this path of short term financing. If this situation continues, expect companies to slowdown their spending which would further hurt the economy.

It is likely to take time for the debt markets to return to a more rational environment as they work through the transition from an overheated and risky lending practice to more rational and sober pricing of credit. There are many former loans that are on the books of banks hedge funds, pensions, and other institutions that do not have sufficient documentation of the value of the underlying asset. It will take time to determine the value of these assets.

Then there all those adjustable rate mortgages that are causing so many borrowers problems. They are seeing their initial rates jump up substantially and their rates will go higher over time. Yes, they might be able to convert to a fixed rate if they can find the financing or if the government steps. But they will still have a hard time making the payments. They got into the house with a 2-3% “teaser rate.” If they were to get a fixed rate it would be in the 6.5 to7% area. That would be a big payment increase. 

The questions to ask is will a rate cut help solve this problem? Well it might a little. What really needs to happen is the lenders and those with the loans need to work out the problems they have created. Lowering the rate will only make it easier for them to get new loans at lower rates. It does not fix the real problem of mis-pricing the risk in the loans. 

Also, looking at the yield curve it is very apparent that investors are expecting lower rates in the future and there is a flight to safety as we have seen the rate on the 10 year Treasury note fall about 100 basis points in about 6 weeks. This is a big move. By the way if you are interested in the yield curve and bond trading you might be interested in Analysing and Interpreting the Yield Curve (Wiley Finance)  by Moorad Choudhry does a good job explaining how to trade and invest using the yield curve. Investors interested in the bond market will find this book helpful.

The Big Day at the Fed and for Bernanke

Many people believe that September 18, 2007 will be the Ben Bernanke's and the Federal Open Market Committee' Biggest Day in many years. The debt markets are anxiously waiting for the announcement that comes after the meeting on whether they cut the Federal Funds rate. In his speech in Jackson Hole, Bernanke made it clear that they are closely watching whether the turmoil in the credit markets is causing problems for the economy.

Curiously, if the market get what it wants, a rate cut, then it is likely that is a sign that the economy is in trouble. A recession will not be good for the market, so investors should be careful what they ask for. Yes, a rate cut might help out the credit problems a little. However, investors need to look more closely as why the Fed is lowering rates. Basically, it is the economy, not the credit markets.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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