An Investors View of US Fed Interest Rates and Liquidity Moves

By: Hans_Wagner

Reading the Fed's Tea Leaves

The Federal Reserve has indicated they want to be more transparent with the markets, believing that it will be better for all market participants. Before the Federal Open Market Committee (FOMC) meeting on December 11, 2007 several of the members of the Fed spoke before various groups seeking to explain their thoughts about the economy and interest rates. As a result many economists and investors felt the Fed would take the necessary steps to help the U.S. economy avoid a recession by lowering the Fed Funds rate 0.25% to 0.50% and lowering the discount rate at least 0.50% to help provide the liquidity many banks need. Then we learned they only lower the Fed Funds and Discount rate by 0.25%. The U.S. markets fell dramatically.

Before the U.S. markets opened on December 12, 2007 in cooperation with Canadian and European Central Banks the Fed announced an auction program to provide liquidity to the banks that need it. So are we missing the messages or is the Fed unable to communicate effectively. And what investing thesis can we make from this insight?

What the Fed is Saying

Let's first take a look at there messages. The Federal Open Market Committee (FOMC) lowered the Federal Funds rate by 0.25% to 4.25% and the Discount Rate by 0.25% to 4.75%. In their press release they stated that “…strains in financial markets have increased in recent weeks. Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time.” The problem is the financial institutions that need access to liquidity (cash) probably cannot borrow from other banks at 4.25%, but have to use the discount window at 4.75%, which increases their interest costs. It also brings unwanted notoriety to the firm. The market had hoped the Fed would lower the discount rate more to bring it closer to the fed Funds rate, to help improve the liquidity of the financials. The Fed did not and the market reacted quickly, led by the financial sector dropping 4.9%.

In the next paragraph they address the prospects for inflation saying “… the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.” This is probably why the Fed did not lower rates by 0.50% as some had hoped. They are still worried about inflation. As noted later, it turns out they might be right.

Following the Fed rate decrease announcement the Central banks in Europe and North America moved Wednesday to increase the amount of money they could lend to banks and to make it more readily available in an attempt to ease the credit squeeze. It was the first time since the Sept. 11, 2001, terrorist attacks in New York and on the Pentagon that these central banks have coordinated their support of financial markets.

According to Bill Gross chief investment officer of Pacific Management, “We have a Fed now that seems to understand the liquidity problem of the marketplace," continuing Mr. Gross said "These measures, while limited in size and with limitations in acceptance of collateral, should certainly instill a measure of confidence to the private market."

The move by the central banks should get more money to banks at interest rates lower than what they would have to pay if they borrowed at the Fed's discount window. The Fed will auction up to $40 billion in loans to banks at two auctions of $20 billion each on December 17 and December 20 and undetermined additional amounts at two auctions in January. The Fed also said it was making funds available to allow the European Central Bank to lend $20 billion and the Swiss National Bank to lend $4 billion to European banks that needed to borrow dollars. The third and fourth auctions will be on Jan. 14 and 28.

The Fed said that the new auction process should "help promote the efficient dissemination of liquidity" when other lines of credit were "under stress."

The experience gained from the four scheduled auctions would be "helpful in assessing the potential usefulness" of this new process to provide funds to U.S. banks, the central bank said.

I believe the Fed was surprised by the markets reaction to their announcement. However, with Ben Bernanke trying to be more transparent, I believe we may see more commentary and possibly other Fed actions in the coming weeks and months. In the third paragraph they say “The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.” To me this means they are ready and willing to act to inject more reserves and liquidity into the banking system as indicated by the auctions. They also will be speaking to the markets in the coming days and weeks to try to calm the markets that the Fed understands the problems and is acting appropriately. 

Inflation Raises its Head, a Little

According to the Labor Department Consumer prices rose 0.8% in November, lead by higher prices for gasoline. Economists had expected the CPI to be 0.7%. Prices for apparel, drugs, housing, and arilin3e fares also jumped up. As a result core inflation as measured by the Core CPI, which excludes food and energy, rose 0.3%, above the expected 0.2% and the biggest advance since January 2007. This raises concern that inflationary pressures are increasing and will limit the ability for the Fed to cut rates further to help counter the slowing economy. The core CPI is now up 2.3% annually, up from 2.2% a month ago. This is above the Fed's target of 2%. And the fastest annual rate since April 2007. 

In looking at the detail, wages, adjusted for inflation have fallen for two straight months. If real consumer earnings fall, it will hurt consumer spending which makes up more than 70% of the U.S. economy. This could cause the U.S. to go into a recession.

In other sectors, energy rose 5.7%, gasoline increase 9.3% and is up 37% over the past year. Transportation costs rose 2.9% due to higher fuel costs and air fares. Housing prices rose 0.4% with the owners-equivalent rent rising 0.4%, probably due to the move to renting vs. buying homes. Food prices rose 0.3%, led by higher prices fro fresh vegetables, fruit and dairy products. Surprisingly, apparel rose 0.8%, the largest gain since April 1999. Medical care cost rose 0.4%, 5.0% above a year ago. Hospital related services climbing 0.6%, a 7.9% increase over the last 12 months. 

In short, it looks like the Fed was right to be worried about rising inflation as we are seeing higher prices in most sectors. Their focus on inflation will hinder their ability to use lower Fed Funds rates to help the economy avoid a recession. 

What's an Investor to Do

First of all it looks like the U.S. economy will be in a recession in the first quarter of 2008, if we are not already there now. The financials typically lead the market down followed by the consumer discretionary and industrials. Expect the slow down in the U.S. to impact global growth which will hurt those companies that depend on emerging market performance. Even though global growth is slowing it will mitigate the impact of the U.S. recession especially for those companies that have significant exposure to the emerging markets.

It looks like inflation is becoming more of a problem though a recession will assist the Fed in this fight without them having to do much. As a result they may still be able to continue to lower rates in the future.

With this view of the economy as background, investors who can properly interrupt the Feds moves will be more successful. This is especially important as the Bernanke led Fed seeks to be more transparent and creative in their moves. To that end I expect several more rate reductions possibly reaching 3.25%. The Fed will also employ other measures at their disposal to encourage a recovery without causing an increase in inflation.

As a result we need to re-position our portfolios to reflect this new reality by following a few important investing themes:

Theme One: Expected continued problems in the financial markets to last for at least three to six months as all parties work through the problem loans. The Federal Reserve will continue to work creatively to offset creating positive surprises when they announce their action. As a result financials should be avoided on the short side as these surprises can cause sudden losses. Hold off entering into any position in the financials for at least another quarter and most likely closer to the middle of 2008. 

Theme Two: The global growth story will continue though it will slow from the blistering pace it has been on. These economies are improving the financial situation of many people who will start buying a number of consumer products especially better food and consumer staple products. Look to acquire companies that will benefit such as agriculture and consumer staples.

Theme Three: With the slow down in the economy the markets will decline. Look to sell into strength and buy SDS, QID and DUG on that strength to help hedge against further moves down.

For now I expect the market reaction to be relatively short lived, maybe a couple of months before it finds a bottom and begins to consolidate there. We have yet to see the technical's fully break down, though there are several signs that an end to the bull market is over for now. As a result it will pay to be conservative, remaining in cash, buying selectively and shorting the overall market on and short term up swings. You may also short individual stocks that present a good case.

The Bottom Line

The Federal Reserve is trying to be more transparent and they are willing to employ creative approaches to solve specific problems in the markets. As the U.S. slips into a mild recession, I expect the Fed to continue to lower rates to encourage growth. While inflation will be a concern, the slow down in the U.S. economy should keep it under control so the Fed can lower rates and without fear. The themes mentioned will help guide investors to structure their portfolios to adapt to the changes in the market. I expect the recession to be mild so the stock market should only pull back for a short while before turning back in anticipation of a recovery.

For those interested, Stock Market Logic: A Sophisticated Approach to Profits on Wall Street (Dearborn Financial Publishing) by Norman Fosback is a valuable book on many stock market indicators and how to assess the health of the market.

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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