FYI | Dec 12 2007
By Greg Peel
Bah humbug. Ben Bernanke proved to be more of a Scrooge than a Santa last night as far as Wall Street was concerned, managing to disappoint the market and deflate the previously jolly pre-Christmas mood. The Fed lowered the cash rate by 25 points to 4.25% and the discount rate by 25 points to 4.75%.
A minority of traders had been expecting a 50 point cut in the cash rate. As it was, the committee voted 8-1 in favour of a 25 point cut, with the dissenter pushing for 50 points. While these traders would have been disappointed, the great majority were assuming a 25 point cut. So this is not the great source of disappointment.
The great source of disappointment lay in the discount rate cut, and in the wording of the statement which accompanied the Fed’s decisions. The market had come to expect that given the second wave of tightening in credit markets, and the widening of the credit spread from Fed funds to Libor, that the Fed would bring the discount rate down a full 50 points to be only 25 points above cash. This is the rate at which banks can borrow money directly from the Fed, and it is the banking system that is really hurting. The more macro economy is not quite as dire, so 25 is a nice start there.
The problem with the wording of the statement is that it contained no sense of urgency:
“Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.”
To many, this statement suggests a disconnect between what the Fed is seeing and what everybody else is experiencing. It is almost dismissive, and more akin to “take two of these, get some rest and you should be fine in the morning” rather than “we’re going to admit you right now and start you on a course of strong antibiotics”.
Moreover, despite inflation readings apparent in recent economic data releases remaining largely benign, the Fed was still banging that old inflation drum:
“Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.”
The Fed did not include one of its “balance of risks” paragraphs in this particular statement. Observers were hoping the Fed would finally get tough and suggest the balance of risks was looking ominous. The only real positive from the statement is that the committee has left the door open to more easing down the track:
“Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. 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.”
With that, the Dow fell 294 points or 2.1%. The index had actually rallied another 53 points prior to the announcement, so all in all in was an almost 350 point negative reaction to the Fed. This puts the Dow only about 50 points above its close last Tuesday, after a week of positive sentiment. The S&P and Nasdaq both fell a more hefty 2.5%.
It is no surprise that it was the financials hit hardest. Home builders and related sectors also copped it. To add to financial weakness, General Electric – a Dow component and a significant financial services company – announced renewed guidance for 2008 which, although positive, missed the Street’s expectations. GE fell over 2%.
Just as the Dow affected a major reversal, so too did bonds. The flight to safety which had been the feature of this second wave of credit crunch had dissipated last week, mostly on news of Arab capital injections and the Bush subprime bail-out plan. The 2-year yield had risen back over 3% quite sharply and the 10-year over 4%. But last night the tide turned and everyone rushed back in. The 10-year yield fell some 15 basis points to be back under 4% and the 2-year dropped around 20 points to be back under 2.9%. These moves are very substantial in one session.
In the meantime, Libor remained steady at 5.11%. Therein lies the dilemma. Libor is the rate at which banks lend to each other and off which most reset mortgages rates are based. The Fed has now cut the cash rate (which is only a “target” rate) three times for a total of 1%, but Libor has only risen in defiance. Cash may be at 4.25%, but that is not a rate anyone can find finance at. The discount rate, at which banks can go directly to the Fed for funds, has only been reduced to 4.75%. While this is 36 points under Libor, it is still not really enough incentive for banks to go the the discount window. For if a bank goes to the window, everyone immediately assumes it is in trouble and will steer clear. But if the discount rate were sufficiently lower than Libor then a bank would consider taking that risk. It’s not – and that is why the market is disappointed.
US dollar traders had clearly been expecting more from the Fed, or at least it was a case of buy the rumour, sell the fact on the 25 point cut. The US dollar bounced against all currencies other than the yen, which saw carry trade unwinding. The Aussie thus fell over US1c to US$0.8732.
This, of course, upset the gold market. After putting on US$14 yesterday gold fell US$11 to US$797.50/oz last night. The market had been looking for more from the Fed.
Base metal markets were largely unmoved by the close, with traders taking the 25 points on board and basically having a rest. Oil, however, bucked the trend, rising US$2.16 to US$90.02/bbl despite the stronger dollar. The reason was unrelated – a snow storm in Oklahoma had caused a pipeline shutdown. Oklahoma is the delivery point for WTI futures obligations.
The SPI Overnight fell 104 points.
Attention now turns to January 30, when the Fed holds its next meeting. The Fed finds futures market has already factored in a better than 90% chance of another 25 point cut.