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.

Here’s a chart of +50 years of the intended Federal Funds rate:

Now is an appropriate time to take a step back and look at the bigger picture because what the Fed has just done is extremely rare.

It has reduced the interest rate by more than 43% in less than 6 months. To find such a frantic slashing of rates we’d have to go back to the Volcker years in the early 1980’s.

The only other time in recent history that is remotely similar is the aftermath of the 9/11 tragedy in late 2001.

What makes it intriguing is that unlike the 1980’s and 2001 when everyone knew something horrible had gone wrong, we don’t really have that now. I think it will take some time for us to understand just what happened.

It seems surreal now as we are going through it. Perhaps the only way to understand it is through the perspective of time. Who would have believed that the current credit crunch makes the 1998 crisis pale in comparison?