Trader’s Narrative

So the Fed had a working weekend. On Sunday they cut the discount rate by a quarter percent to 3.25% and today, they cut the Fed Funds rate by 75 basis points to 2.25%. The market almost unanimously rejoiced and rushed to buy with both hands, eventhough the Fed Funds futures indicated most were expecting a full 1% cut.

Is that enough? are we out of trouble now?

I don’t think so (just yet).

One of the theories of why we are in such a fine financial mess today is that we’ve had lax monetary policy. I’d like to propose another, without necessarily disagreeing or disproving that school of thought.

It goes something like this: while lax monetary policy is bad, what we are dealing with now isn’t just the after-tremours of the Greenspan bubble era. Since his first days as Chairman, Bernanke has refused to listen to the bond market.

By ignoring it, he has compounded the problems that were there to begin with. And instead of giving the economy the flexibility it needs to go through a short transition period to “fix” itself, he has in effect, extended this painful process (indefinitely).

I’m referring to Bernanke’s insistence to remain, month after month, firmly behind the 3 month Treasury Bill rates. This is something that I noticed last summer, when I wrote that the Fed should cut rates immediately.

And if you take a look at this long term chart of the Fed funds rate compared to the 90 T-Bill rate, you can easily compare the Bernanke Fed to the Greenspan Fed. Greenspan let the market lead him by the nose. His talent was in making every one believe he was in charge… the Maestro, orchestrating the economic symphony, while in fact, he was just flailing his arms around randomly.

Which brings us to today’s interest rate cut:

Unfortunately, since last month the gap has gotten worse! The Federal Funds rate gap is now 133 basis points away from what the short term bond market is saying it should be at.

So while another 75 point basis cut is dazzling, until the Fed actually gets in front of the short term bond market for at least a day or week, I can’t see this mess getting mopped up.

And believe you me, there is a fine mess out there. The Bear Stearns(BSC)/JP Morgan Chase (JPM) story has grabbed everyone’s attention but there is a lot more happening out there:

MF Global (a subsidiary of MAN Capital) was taken behind the toolshed
Carlyle Capital Corporation is about to go tits up
Hedge funds and private equity funds are being closed right, left and center

So on the one hand, things are darkest before dawn but on the other, the way Bernanke is dragging his feet worries me.

As the Fed Funds futures indicated, we got a 50 basis point cut. And since this was what the market expected and had come to rally for ahead of time, we got a muted response. I wrote early this morning:

“If we do get exactly 50 basis points, we could flail around and end the day unchanged for the most part.”

The text of the Fed announcement hints that there will be more rate cuts to come:

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

The Fed’s scramble to lower interest rates is much more than just a preoccupation with the housing market or the stock market slide or the liquidity crunch or the multi-billion dollar Societe Generale fraud or any other one variable. It is about the US economy’s inevitable slide into a recession.

With the interconnectedness of world economies, you can bet this will quickly seep into Europe and Asia. I’m already hearing from friends and family overseas that business is slow.

Here’s an updated graph from Google Trends:

Notice how the first blip coincides with the Asian “flu” correction in the spring of 2007. But now its off the charts!

So the Fed came in with a 25 basis point cut, as expected by the markets, and everything went to hell in a hand basket. Hmm, I wonder if you can tell when, exactly, the news came out:

The bond market closes at 3pm, while the equity markets close an hour later. So stocks had one more excruciating hour of pain.

Within less than 2 hours, it had erased almost 4 days of uphill climbing. This is what I wrote a few days ago:

With the impending FOMC decision, traders are going to be twitchy and nervous. Although a 25 basis point cut is baked in, until we get confirmation, the market will probably not trend.

It is all about expectations in the market. Since a quarter point cut was already expected and priced in, the market had rallied accordingly in the days leading up to it. The only thing that would have kick started another rally would have been a half-point cut.

Recession Forestalled?
According to Morgan Stanley, recession may be inevitable now. In a new report written by the bank’s chief US economist Dick Berner (the resident bull) the prime culprit is the credit crunch which has lasted more than 17 weeks and brought the housing market to its knees.

…financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available. Money-market rates have risen significantly, and yield spreads over those money-market rates on loans have stayed high or widened.

The bond market has already priced in the next rate cut in January - another 25 basis points. And into the summer of next year, the Fed Funds Futures market is now estimating a federal fund rate of 3.75%.

The market is drifting higher this morning, as it tends to do ahead of Fed meetings. This is the defining moment for Bernanke. The first chance he will get to create his legend and legacy.

Maestro vs. Helicopter Ben
With the upcoming release of his memoirs, Greenspan has been all over the news with attention grabbing sound bites. He pontificates on a lot of topics that he was silent about during his tenure as the “Maestro”: tax cuts, the Iraq war, the mortgage and housing market, etc.

Interesting that he only speaks out now when he is enjoying the freedom of retirement. When had the power to actually do something about these things he was conspicuous in his silence and acquiescence. In any case, today, Helicopter Ben finally gets the limelight.

25 bp or 50 bp?
At 2:15 Eastern time we’ll find out. A 25 basis point cut is a foregone conclusion since it has been priced in 100% since mid August by the Fed Funds futures market. Meanwhile the same market tells us there is a 75% chance of a 50 basis point cut. Personally I think they should go with the latter.

Not because I’m talking my book, but rather because that’s what the bond market is saying. Right now the 90 T-Bill rate is around 4.05%. While the Fed Funds rate has been 5.25% since June 29, 2006, since this spring, the bond market has been signaling repeatedly that it should be lowered.

What do you think will happen? No cut? 25 bp? 50 bp?

Leader or Follower?
A prolonged gap of around 100 basis points is simply too much. The Fed doesn’t have a choice. They have to lower the rate. If they don’t it will be a market shaking decision and as far as I know, the first time they have decoupled from the fixed income market.

I find that highly improbable because the short term T-Bill rate leads the Fed by the nose. Of course the Fed would hate for this to get out but it is the truth. Each and every major trend change in rates has been preceded by the free market and later followed by the Fed.

That isn’t hard to fathom once you realize the incredible power of free markets for price discovery. To see what I mean, click below to see a long term chart of the Fed Funds rate along with the 3 month T-Bill rate.

Click To Enlarge Graph: