FYI | Nov 01 2007
By Greg Peel
Last night the US Federal Reserve cut its target funds rate by 25 basis points to 4.25% and simultaneously cut its discount rate by 25 basis points to 5.00%. This is what the market was looking for, at a minimum, but the Fed’s accompanying statement appeared to put paid to any idea that another 25 point cut would be forthcoming in December.
From the Fed statement:
“Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance.”
It got that right. The US third quarter GDP was released prior to the opening bell and surprised everyone with 3.9% growth. Analysts had expected a 3.1% result, following on from the second quarter’s 3.8%. Most prominent in the numbers was a 1% contribution by US exports, which have seen a boom as the greenback has accelerated its slide. This negated the -1% contribution to GDP from the weak housing sector. The rate of growth all up was the strongest in 18 months.
Financial market pressures have definitely eased somewhat, but only from their panic points back in August. Commercial prime lending is proceeding with caution at higher credit spreads, but there is little doubt the asset-backed commercial paper market is still far from fully thawing. The Fed continued:
“However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.”
Which is to suggest that while the third quarter may have surprised, it takes time for economic impacts to flow through to the GDP numbers. Analysts are expecting growth to fall to as low as 1.5% in the fourth quarter, and for the first quarter ’08 to be equally weak. For the US to slip into an official recession, both these numbers would need to be negative (or indeed two consecutive subsequent quarter results).
In terms of forestalling a recession due to financial market disruption, this may well be the case, however the results are not reflected in the banking sector. Banking sector stocks are still 2.3% lower on average after the 50 point cut in September. The reason why US stock markets have pushed themselves rapidly back towards all time highs is all about global export markets and rising commodity prices. That is why both the technology sectors (where the US leads the world in innovative products) and the materials sector have boomed, and been the prime stock market drivers. It’s all about the weaker dollar, and accelerated dollar weakness is all about the Fed’s monetary policy easing. This fact is not, however, lost on the Fed:
“Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.”
That last sentence had been present in just about all Fed statements this year until such time as the credit crunch threw uncertainty into the mix. While core inflation has remained surprisingly tame the Fed is now recognising that a weaker dollar is indeed an inflationary influence. It is a return to “hawkish”. Does that mean the end of rate cuts?
“The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. 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.”
Which is a strong indicator that there will not be another rate cut on December 11. We are back on hold, waiting to see how things play out. To keep cutting indiscriminately would be to fuel an inflationary fire, so it’s time to stop letting Wall Street force the Fed’s hand and to keep a close watch on the data.
So what did the market think? Well despite having bought up stocks on every bit of weak news recently on the anticipation of a 25 point cut, or maybe even 50, the Dow still closed up another 137 points, or 1%. The S&P added 1.2% and the Nasdaq led with a 1.5% rise. But it was far from smooth sailing.
The Dow was strong from the get-go, up 100 points not only as a response to the strong GDP number, but also to a preliminary employment report that suggested Friday’s official employment numbers will not be as bad as expected. The scene was set.
Out came the Fed – 25 points, right on the money. But the language indicated no further cut. Sell!
The Dow then lost all of that 100 points, and some, in 15 minutes from the release. But suddenly, the mood changed. They began to buy, and buy and buy, and the Dow added 170 points in half an hour. They got their cut, the economy is not looking recessive, God’s in his heaven and all’s right with the world.
Was that too much? In the next half an hour the rally halved and we were right back where we started before the Fed announcement. But a final kick brought renewed strength and the Dow finished on an up-tick, up 137 on the day.
Once again, one is forced to wonder what ever it might be that would curtail the US stock market’s exuberance.
It certainly isn’t the oil price. Boosted by an announcement that US inventories had again fallen – not risen as expected – and fuelled by a further slide in the US dollar despite the rate cut being basically what everyone expected, oil put on a huge US$4.15 to be US$94.53/bbl at the close. In the after-market, oil pushed on to US$95/bbl.
Gold’s reaction was similar. Gold pushed up another US$14.70 in the spot market to be US$796.30/oz. However, it too continued its rally in the after-market and hit the magic US$800/oz. The US dollar fell against major currencies with the exception of the yen, given a Fed rate cut gives a green light to risk and that means carry trading. After pushing higher on more strong economic data yesterday, the Aussie surged on to US$0.9334.
There’s little point in noting base metal prices in London, as they had closed before the Fed announcement. New York prices did not show much of a reaction, possibly waiting for London’s response tonight.
The SPI Overnight put on 35 points.
So where to from here? Now that speculation of yet another Fed rate cut has all but been crimped – the Fed funds futures market cut its expectation of a December rate cut from 100% to under 50% last night – we are talking about a market that should be moving simply under its own steam. But the buzzword is “bifurcation”. The US domestic economy is no longer of greatest significance, it’s all about the global economy. While the Fed has cut rates in an attempt to stem the tide of disaster in the domestic economy, all it has managed to do is drive the US export market and global commodity prices. Since the September cut, banking sector stocks are off 2.3% and housing 1.5%, while the technology and material sectors have rallied 10% each. The Nasdaq closed up over 5% for the month of October alone. Google shares rose from US$600 to US$700 in 17 trading sessions.
And last night’s Fed cut made no difference either. One might have assumed a bounce in the banking and housing sectors, but that wasn’t to be. It was back to techs and materials, oil and gold. As Dennis Gartman put it on CNBC this morning, it’s a “melt up”.
