Daily Market Reports | Dec 17 2008
By Greg Peel
The Dow closed up 359 points or 4.2% while the S&P gained 5.2% and the Nasdaq 5.4%.
The session opened with the November CPI reading, a measure that was always going to have an influence on just how aggressive the Fed could be in its intended monetary policy easing. It was only three months ago that the Fed was warning Wall Street not to expect further aggressive rate cuts if inflationary pressure remained consistent. Even as commodity prices began to fall, the Fed wanted to be sure entrenched inflation did not remain in the system.
Fast forward to now and we find a Wall Street worried about the possibility of deflation. Deflation is even more destructive than high inflation. High inflation erodes savings but it actually eases debt burdens given the value of principle remains fixed in nominal dollars while prices and wages rise, allowing debt to be repaid more quickly. In a deflationary scenario, it might seem nice that prices come down but so do profits and wages (for those still in a job) while nominal debt remains fixed. You have less and less money with which to pay back debt.
In October Wall Street was shocked when the CPI fell 1% – falling for the first time in decades. In November the CPI fell 1.7% – the biggest fall since 1947. It was not hard to tell where the price declines came from. The core CPI (excludes food and energy prices) was flat in November having been down 0.1% in October.
The CPI reading was not only a green light for the Fed to go ahead and cut aggressively, it was a hurry-up. Wall Street had expected a cut from 1.0% to at least 0.5% with some suggesting 0.25% was possible. But the Fed went even further, and in so doing set a new precedent.
The Fed announced that the target for the Fed funds rate would now be set in a range of zero to 0.25%. Not only has the Fed funds rate never been below 1.0% before, it’s never been set in a range before. Throughout the entire credit crisis the Fed has cut aggressively but the real market has always effectively cut even further as short-end government security yields have suggested. The demand for such securities from the market has muddied the waters for the Fed’s attempts to set a “target” rate (which it would usually maintain by injecting and withdrawing funds from the overnight market as needs be). Rather than try to be specific, this time the Fed has simply set a range. And at such low levels of interest rate, a range makes perfect sense.
With the bottom end of the rate now at zero, the Fed has nowhere else to go in managing overnight funds. What to do if things do not improve from here? Well firstly the Fed took another bold step last night and declared that “The Federal Reserve would employ all tools to promote the resumption of sustainable economic growth and to preserve price stability,” and “In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time” (my emphasis).
This might be construed as the famous helicopter at work. Monetarist economics suggests it is fine to print as much money as needed and “throw it out of helicopters” if deflation threatens. Printing money is inflationary, but the Fed is suggesting it is prepared to be inflationary by holding the low rate fixed into the future.
That’s the short end. Clearly to date Fed easing of the cash rate has had little effect. We’ve fallen from 5.25% to 1.0% before last night and the global economy has melted down and credit markets remain tight and banks reluctant to lend. Banks have basically just hoarded any funds they can pick up to shore up their own broken balance sheets, so little of the “looser” money has made its way into the real economy where it is needed. Clearly a big impact has been that mortgage rates had not fallen even as the funds rate was slashed. It is still weakness in the housing market that hangs over the real economy like the darkest of clouds.
Last month the Fed announced it would address this problem by using its balance sheet to buy mortgage-backed securities as a direct means of bringing mortgage rates down. It has not yet done so, but the market has done the rest, moving swiftly into ten-year and thirty-year bonds and agency (Fannie/Freddie) debt in anticipation of Fed purchases and lower yields (higher prices). In last night’s statement the Fed pledged more of the same:
“The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities”
The reason why such purchases do not diminish the Fed’s balance sheet is because the securities remain as assets. This is not the same as a “bail-out” where the Fed really just hands over emergency funds. It is simply a matter of the Fed trying to apply the electric paddles to the chest of the real economy. If the Fed steps in and buys up mortgage securities, agency securities and longer term Treasury securities then the yields on those assets fall. This acts to make mortgages cheaper and encourage home-buying, but also makes US Treasuries a less attractive investment for everyone from pension funds to hedge funds and retail investors. The hope is that it then encourages investors back into the corporate debt market – the market that is effectively “closed” and the cog that has seized in the US economic engine. If corporate credit spreads start to come down, the stock market will react positively.
And the Fed has gone further into the “real” economy by announcing that next year a Term Asset-Backed Securities Loan Facility will be established to specifically extend credit to households and small businesses. The Fed is to become the direct banker to everyone while the commercial banks have remained stunned in the headlights of financial crisis.
As might be expected, Wall Street loved it. The Dow reacted positively to the very negative CPI, expecting it might tip the balance toward a more aggressive cut. At 2.15pm the Dow was up 100 points. But where was the Fed? The clock ticked, and ticked, and ticked until finally about ten minutes late (never happens) the Fed statement was released. And Wall Street quickly realised why it was late – it was an unprecedented policy move. It also came with the unanimous support of all Committee members (was there a late dissenter who needed to be convinced?).
On the release of the statement the Dow jumped, and kept jumping. On the other side of the equation, the US dollar absolutely col-lapsed. Few expected a zero interest rate and no one expected the rate to be fixed “for some time”. The euro shot up from under US$1.38 to over US$1.40 in a heartbeat, which just never happens. The US dollar index crashed. The world has been anticipating an eventually weaker US dollar if the printing presses are to be pushed to the limit, and that’s what is happening. Long-end bond yields and agency yields also collapsed, which is exactly the plan.
Gold shot out of the blocks on the Fed announcement, but gold has already been creeping up in anticipation of “reflationary” policy (money printing) and settled back after the initial burst. At last mark it was up US$18.30 to US$855.40/oz. The Aussie leapt more than two and a half cents to US$0.6939.
Commodity markets closed ahead of the Fed release, so neither oil nor base metals have had a chance to respond to a much weaker US dollar. Oil closed up all of US9c to US$44.60/bbl ahead of today’s OPEC meeting in Algeria. Base metals closed mixed to weak with copper falling over 1%, nickel 3% and lead 5%. Tonight’s trade might be different. Oil’s response, however, will be beholden to the level of announced OPEC production cuts.
The SPI Overnight rose a rather cautionary 58 points or 1.6%.
