Will a Fed rate-cutting program bail out Wall Street?

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In my posting of August 17 I gave reasons why the Fed’s cut of the discount window rate on that day did not come as a surprise. Given the severity of the credit squeeze and the ramifications for the US economy at large, I also commented that a number of rate cuts in quick succession could not be ruled out.

BCA Research, the highly regarded Montreal-based economics research house, said last week: “… the Fed can be expected to ease aggressively if the economy appears headed towards recession”. The state of the US economy is therefore of critical importance for how monetary policy unfolds.

The next meeting of the Fed’s Open Market Committee is scheduled for September 18. Although not a perfect predictor, the 30-day Federal funds futures contract that expires in October 2007 seems to imply a Fed funds rate of 4.90% and is currently pricing in a 100% probability that the FOMC will decrease the target rate by 25 basis points to 5.00% at the September meeting.

30-DAY FED FUNDS FUTURES*

blog-1-f-29-aug.jpg

* The implied interest rate is obtained by subtracting the price of the October Fed funds futures contract from 100.
Source: www.cbot.com

Interestingly, just more than a week ago the implied Fed funds rate was as low as 4.78%, which would have argued for a 50 basis points rate reduction. The graph also shows that immediately prior to the meltdown of financial markets in July, there was no expectation of a rate cut in August or September.

Although the prospects of lower rates calmed some nerves and provided a boost for equities last week, the real question is what typically happens to stock prices subsequent to the commencement of a Fed rate-cutting program.

William Hester of Hussman Funds offered the following insight: “Since 1955 there have been 11 periods where the Fed lowered rates at least once after raising them multiple times. Average returns have been strong during these periods. Following the first interest rate cut, the S&P 500 advanced at annualized rates of 23.9% over the following 6 months, 18.3% over the following 12 months, and 18.7% over the following 18 months.

“Good returns followed nearly every instance that a rate cut took place at low valuations. In contrast, rich valuations have produced far more tepid returns. When the S&P 500 price/peak earnings ratio has been above 17, the market’s annualized return following the initial rate cut was –2.3% over the following 6 months, 5.9% over the following 12 months, and 6.2% over the following 18 months.

The chart below shows the average 6-month, 12-month and 18-month returns (annualized) following a first-time cut by the Fed. The two sets of bars on the left show the returns during periods when price/peak earnings ratios were less than 15 and in periods where the yield curve was either upward sloping or inverted. The two sets of bars on the right show both yield curve environments, but during periods when the price/peak earnings ratio was greater than 17.

blog-2-f-29-aug.jpg

Source: www.hussmanfunds.com (click here for here for a direct link to the full article)

Based on the evidence above, we probably find ourselves somewhere between the two sets of bars on the right, i.e. with a price/peak earnings ratio in excess of 17 and a yield curve that is slightly positive.

This brings us back to the original question: Will a Fed rate-cutting program bail out Wall Street? In my opinion easier monetary policy at best argues for mediocre returns, especially as the weaker economic environment starts threatening corporate earnings growth at a time when price/peak earnings ratios are not exactly at bargain levels. We have entered a difficult investment environment, and one should be careful not to dispel the possibility of further price declines. Be cautious.

OverSeas Radio Network

1 comment to Will a Fed rate-cutting program bail out Wall Street?

  • stevo

    Good hard question!

    The difficulty of providing a reasonable answer is compounded by the fact that money will be invested someplace, all of the time. This riddle calls into play not only positional but locational considerations.

    I view the present state of the US financial markets as much like John Law’s Mississippi bubble economy in the France of 1719-20. In accordance with Gresham’s law, sound money was driven out of circulation by fiat notes generated to encourage the rampant speculation required to support out of control, soverign expenditures. The whole house of cards was soon to collapse with the most severe and lasting geopolitical implications.

    Law’s canny assistant, Richard Cantillon, was a superior speculator who actually made and escaped with a fortune from this fiasco. Cantillon timed his purchases and sales of the Mississippi Company shares by means of capitalizing upon intermediate trends in the foreign exchange markets. When the Franc went into a tailspin, he rapidly exited. [Vide: Murphy, A. E. (1986). "Richard Cantillon: Entrepreneur and Economist." Oxford University Press.]

    In like manner, I feel that the anticipated trend and level of the US dollar index will determine whether interest rate decreases will be enough to offer meaningful support to the US share market. If the Fed and Treasury can manage to hold the index above 80, or if they can engineer a gradual, managed decline to somewhere around 72, then juggling rates might be enough. However, if the dollar quickly craters, all world markets will plunge, confidence will collapse, hot money will flee to safety, debt service will become glaringly insufficient to maintain the charade that the debt mountain reflects a corresponding asset mountain, and people everywhere, both the mighty and the insignificant, will suffer the most bone-crunching deflation the world has ever known!

    Since there is a positive correlation between movements in the dollar and interest rates, any decrease in rates will have to put a downward pressure on the already battered greenback. Also, President Bush has announced that another $50 billion will be needed to keep the sulfurous fumes from seeping out of the sinkhole that is Iraq. In a debt-based money system, these funds will be created by ledger entry, further debasing the “value” of all other dollars presently in circulation. US monetary policy is now like a speeding locomotive in the darkest of night, hurling towards a bottomless chasm over which there is a broken bridge.

    If deflations are often associated with the aftermath of wars, I wonder what will be the legacy of the West’s current policy vis a vis terrorism — war without end? Isn’t it wonderful that safe havens exist, such as Switzerland?

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