Why the Fed’s rate cut did not come as a surprise

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Since hitting a peak on July 16, the meltdown in global stock markets has taken place with lightning speed. Given the fact that more than 10% (using the Dow Jones World Index as a proxy for global stocks) has already been wiped off investors’ scoreboards, the question invariably is how low can we go.

Has the Fed come to the rescue of markets with today’s cut of the discount window rate from 6.25% to 5.75%? Before getting stuck in analysis, let’s take a look at a very useful diagram devised by my colleague Ryk de Klerk of Plexus Asset Management. The chart below summarizes the cause of the current global liquidity crisis and the eventual intervention by major central banks in an easy-to-understand manner.

ag-1.jpg

Source: Plexus Asset Management

In the midst of the current crisis one should concentrate on what is happening and what can be expected by central banks, especially the Federal Reserve. The major concern of the Fed is undoubtedly the potential impact of the crisis on the US economy, especially with banks having been forced to tighten their lending standards due to deteriorating balance sheets.

The Fed’s July Senior Loan Officer Opinion Survey for the second quarter revealed that banks have tightened their lending standards for consumer loans in the second quarter and as a result of the severity of the crisis are currently making their standards even more onerous.

ag-2.jpg

Source: Federal Reserve Board
*Est. = estimate by Plexus Asset Management

The same is probably happening with corporate clients.

ag-3b.jpg

Source: Federal Reserve Board
*Est. = estimate by Plexus Asset Management

In recent history, whenever banks tightened their lending standards for corporate clients for whatever reason at the time when the Fed pursued an accommodative monetary policy, the Fed intervened.

At the end of January 1996 banks started to increase their lending standards. The Fed cut the Fed funds rate to “… keep the stance of monetary policy from becoming effectively more restrictive …” (see 1 on chart below).

The Fed cut the Fed funds rate in September 1998 as the Fed organized the rescue of Long-Term Capital Management, a very large and prominent hedge fund on the brink of collapse (see 2 on chart below).

In 2001 the Fed cut the Fed funds rate aggressively as it was very accommodative in its monetary policy, but the banks kept their lending standards extremely tight at a time when massive corporate scandals unfolded (see 3 on chart below).

This brings us to August 2007 (see 4 on chart below), explaining the Fed’s rate cut of earlier today.

ag-4.jpg

Sources: Federal Reserve Board, I-Net Bridge

Also, when the Fed cut rates in 1996, 1998 and 2001 the real Fed funds rate was not dissimilar to the current real Fed funds rate.

ag-5.jpg

Sources: Federal Reserve Board, I-Net Bridge

But the real Fed funds rate is currently more restrictive than in 1998 given the state of the US economy.

ag-6.jpg

Sources: Plexus Asset Management, I-Net Bridge

Tightening of lending standards is of major concern to the Fed regarding future economic growth and it will not come as a surprise to see the US ISM Non-manufacturing Purchasing Managers’ Index (PMI) declining significantly.

ag-7.jpg

Sources: ISM, Federal Reserve Board

And keep in mind that the non-manufacturing component accounts for more than 80% of the US economy.

ag-8.jpg

Sources: ISM, I-Net Bridge

The Fed has always provided liquidity (as measured by zero maturity money growth) when banks tightened lending standards excessively and was probably acutely aware of the imminent credit crisis by significantly adding liquidity since the first quarter of this year – as it did in 1998 before lowering the Fed funds rate.

ag-9.jpg

Sources: Federal Reserve Bank of St. Louis, Federal Reserve Board

The level of inflation is of no concern to the Fed in the decision to intervene. On all occasions of Fed intervention the inflation rate (CPI) was higher than it is currently, except in 1998.

ag-10.jpg

Sources: Federal Reserve Bank of St. Louis, I-Net Bridge

It is not inconceivable that rate cuts could follow the same pattern as in 1998, with two or three cuts in quick succession.

ag-11.jpg

Source: I-Net Bridge

Without the Fed providing liquidity, the economy could be in deep trouble, making a recession almost inevitable.

ag-12.jpg

Sources: Plexus Asset Management, I-Net Bridge

What is the typical reaction of markets following a cut in rates? Let’s consider what happened in 1998.

Equity prices soared …

ag-13.jpg

Source: I-Net Bridge

and metal prices started to recover only a quarter later, but the gold price kept drifting lower.

ag-14.jpg

Source: I-Net Bridge

Comparing the markets now with 1998 provides some guidance.

Equities …

ag-15.jpg

Source: I-Net Bridge

Metals …

ag-16.jpg

In conclusion, the recent events have brought forward the roll-over of the US economy and it is likely to remain weak for at least another two quarters. After today’s rate cut the action of the Fed has now firmly moved to centre stage as far as mapping out the direction of stock markets is concerned. It is not clear at all, however, to what extent the US will be able to avert a significant economic slowdown and whether stock markets will manage to stay on the rails.

As far as investment strategy is concerned, the conclusion remains rather to err on the conservative side with whatever you do and not to frown upon holding cash. (Also see my article on “Where to hide from jittery financial markets“.)

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15 comments to Why the Fed’s rate cut did not come as a surprise

  • Joel Ticknor

    Thank you for your excellent “postcards”!

    In your recent writing on gold and a recommended mining fund, you mentioned favorably a Merrill Lynch fund on the London exchange. Is there a US equivalent that you feel comfortable about?

    Thanks!

    Joel Ticknor

  • Charles

    An interesting discussion. Conspiciuos by its absence was any discussion of likely Fed philosophy during this period. The current governors are likely to think differently to those of the Greenspan era. While thats not to say the same actions will not be undertaken by the current fed, I’m inclined to believe they will be happier with some blood-letting on wall street.

    I would also to take care in differentiating between the fed funds rate, discount window rate and a general notion of liquidity.

    First time reader of your blog. I shall track its progress, because I’m in the hedge fund industry, but mostly because I’m a Capetonian in the US.

  • […] Why the Fed’s rate cut did not come as a surprise Since hitting a peak on July 16, the meltdown in global stock markets has taken place with lightning speed. Given the […] […]

  • slick

    Thanks.

    I see quiet a difference between LTCM bailout (isolated event, not real economy-based) versus real estate bubble popping combined with global credit crisis (LTCM * 100+). While certain patterns appear similar, the underlying fundamentals are quite different.

    I’m far from a perma-bear, but they can keep kicking the can down the road for onyl so long – and it’ll only make the inevitable that much worse. That’s EXACTLY what is going on. Man’s hubris and ego. Since when are recessions unacceptable? Since when is such open manipulation of the stock market (read: rigged) acceptable? It’s insane what the Fed (and other central banks) keep doing. They put out one fire, only to create another. How long can this continue until they lose control? And then what? Cycle after cycle, the stubborn idea that the markets shouldn’t deal with reality, but instead will be “saved”? That incentivizes the exact situation we find ourselves in today. This crisis will be averted, but then what? It only emboldens the greedy and corrupt to come up with yet another/different scam.

    Meanwhile…I think there is a major EROSION of TRUST in the financial system, which is goign to come into play at some point soon. The same erosion of the public’s faith in e.g. Congress is happening to Wall St., the Fed, and business leaders. No credibility. How many crises must the public witness before they say “I’m out”. It’s one thing when it’s a single company, like Enron. But when it’s system-wide corruption and abuse? The wealthier amongst us, and the institutions, can keep banging their heads against each other (hedge funds, etc) – but the masses are slowly but surely leaving the casino for a variety of reasons. When the hedgies go long, the market spikes, when they go short, it nosedives – but what does that have to do with the public’s participation in the growth of businesses? Nada. It’s pure speculation – not investment. Everyone knows the PRICES, and stares into their screens, but think very little of the VALUE. Madness.

    What we are witnessing is the greatest information leap ever, mainly thanks to the Internet. Hurray! And what unfortunately is a consequence of more and more people being aware of certain things, is the mass realization of just how rigged and corrupt the game is. (e.g. the popularity of ETFs and index funds because of the knowledge that mutual funds have almost no chance of outperforming the indices). We also see the erosion of trust in people we used to revere and consider EXPERTS. No more. We see the flaws in the data of the studies we used to accept on blind faith. And we see the flaws in the people too (read: full of sh*t).

    Ultimately, this could lead to good things (such as electing better politicans or non-control shareholders demanding more from the executives), but I’m not holding my breath.

  • petr mercovich

    I’m one of Barry’s readers/correspondents from Oz
    Good macro
    Thanks pcm

  • Rob

    The FED 4-Step plan of Economic Management

    Step 1: Uncover problem
    Step 2: Throw money at problem
    Step 3: Problem solved
    Step 4: Uncover problem

    Repeat indefinetly

  • 鄉下人

    I would think the ultimate concern of Federal Reserve is the confidence in the US dollar. Given yesterday slide in x-rate between US dollar against Japan yen, Federal Reserve eventually understands if no action is taken, confidence in the US dollar will be damaged.

  • john clark

    Banks will never lend to anyone who NEEDS money and thats exactly whats happening now. The mortgage banks, brokers and the recent (marginal) homebuyers all need money and they can’t get what they NEED.(as a bonus by cutting off credit to mortgage bankers the Citibanks and Wells Fargos of the world are wiping out a complete class of competitors, SWEET!)

    Fed rate cuts bandage over the problem but they won’t cure it. The federal government needs to take action through Freddie/Fannie to soften the impact of reality on the housing industry and new homeowners.

    Bush was trumpeting the high rates of home ownership a couple years ago but now he mumbles he might permit some help for institutions but do nothing for the overextended home buyers. These are the home buyers he was taking credit for creating a couple years ago. This tough love scenario is likely to create a new foreclosure class in this country unlike anything since the 1930s, rate cuts alone won’t offset their impact on the national economy. Bush is saying “let them eat cake”, it’s easy to tell he’s not concerned about reelection!

  • […] Prieur du Plessis has much more on Fed rate cuts. […]

  • […] Why the Fed’s rate cut did not come as a surprise […]

  • Mike Ho

    The situation in 1998 was very different to today: Global growth was weaker as Asian economies were just recovering from a crisis (today global growth is at a record), and Bernake is conscious of the moral hazard of the the Greenspan put (arguably what caused today’s situation). Injecting liquidity to support specific banks is different to cutting rates for everybody. Central banks don’t want bail out overpaid carry jockeys (HF managers) by cutting rates.

  • […] good charts – Why the Fed’s rate cut did not come as a surprise – Prieur du Plessis’s international investment blog […]

  • […] my posting of August 17 I gave reasons why the Fed’s cut of the discount window rate on that day did not […]

  • Thank you very much for such a great overview of the money cycle and the economic graphs, it was a pleasure to read

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