Fed Rate Cuts May Have Been Counter-Productive

Viewing today's markets, a strong case can be made that aggressive Fed rate cuts have been counter-productive; Fed easing has exacerbated inflationary trends in the commodity and currency markets, while doing little to prevent the repercussions of the bursting of the credit and real estate bubbles. While the Fed has slashed the fed funds rate by 225 basis points over the past six months, commodity price indexes have exploded 35% higher and the U.S. dollar index has plunged a further 10% to new record lows. Last week, as Chairman Bernanke reaffirmed his commitment to rate-cutting, the U.S. dollar sank below the psychological $1.50 level against the Euro.

In exchange for its part in devaluing the currency and reducing purchasing power through extreme commodity inflation, has the Fed at least succeeded in alleviating the credit crisis and arresting the housing price decline? It would appear not. For every form of debt save Treasury bonds, credit markets have gotten progressively tighter since the Fed began easing. One of the most important interest rates for the residential real estate market is Freddie Mac's 30-year mortgage rate, which today stands at 6.24% - 6 basis points higher than year-ago levels. Further, considering that an increasing share of the household budget must be directed to food and energy, as well as other costs that are increasing at a rapid rate, a persuasive argument can be made that the Fed's actions are undermining rather than helping to resolve the problems of housing affordability and supply. Last week, the California Association of Realtors reported that January home sales in California were down almost 30% from a year ago, with median prices sinking 21.9% year-over-year, and the inventory of unsold homes rising to almost 17 months of supply.

The Fed and others who choose to downplay the inflation problem like to cite the low current yields on Treasury bonds. The 10-year Treasury yield finished last week at 3.51%, which is extraordinary given recent trends in the commodity and currency markets. At this yield level, we believe Treasuries are priced to deliver terrible long-term returns given the reality of a government committed to and fully capable of producing inflation. However, in the near-term, government bonds continue to benefit from a huge flight-to-safety bid. Indeed, the strength of the Treasury market has been closely linked with weakness in the stock market and risk avoidance in the credit markets.

Our view has been and continues to be that it would be better for the long-run health of the economy to let the credit and real estate bust run its course, rather than try to inflate our way out of the problem. How can a problem caused by the excessive expansion of credit possibly be solved by creating even more credit? One could argue that the Fed's reflationary efforts have thus far kept the bear market in stocks modest by historical standards. As it stands now, the S&P 500 is down a relatively mild 15% from its October 9, 2007 peak, far less than the 27.5% median peak-to- trough decline in the 12 bear markets since World War 2. Clearly, the decline we have seen in the stock market has been worse when measured in almost anything other than the U.S. dollar (e.g. gold, commodities, and foreign currencies). The stock market has been losing ground at a particularly rapid rate relative to the price of gold. Since the Fed reversed to a policy of easing, the price of gold has risen by over $300 to $970/ounce.

Short-term market forecasts are more than usually hazardous in a highly volatile environment such as this, with strong cross-currents from recession, inflation, investor emotion, and market intervention. Nonetheless, we will observe that Friday's sharp decline left the S&P 500 at 1331, which is at the very bottom end of the 1330-1370 trading range the index has been in for the past four weeks. We have been anticipating a retest of the January 22^nd/23^rd low in the stock market. Last week's high volume downward reversal in stocks, combined with continued upheaval in credit markets, the melt-up in commodities, and the breakdown in the U.S. dollar suggests that the test may come sooner rather than later.

As mentioned in earlier commentaries, we do not think the ultimate downside risk in the S&P 500 is more than about 5% below the 1275 level reached on January 22^nd and January 23^rd. Government sponsored inflation ultimately affects all prices, including stocks. Moreover, the Fed's rate cuts are pushing down yields on money markets and CDs, making holding cash less and less attractive. Currently, $3 trillion is parked in money market funds earning a dwindling return. At some point in the months ahead, these funds will begin to move back into the stock market as investors grow tired of earning a negative real return on their savings.

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This article has 8 comments:

• flatman

  Mar 03 10:53 AM
  The only people who do not seem to understand this are the ones talking on CNBC and those in the Federal government.
• BrucePile

  Mar 03 01:25 PM
  The problem the Fed is trying to fight is money creation. Through all the packaged debt instruments moved off the banks' books and passed around like hot potatos over the last 10 years, we now have $1 in real assets backing about every $30 in potatos. So our wise Fed fights it as if it were your normal economic contraction by creating still more money. This policy of throwing gasoline on the fire has one plus, however. It gives investment in commodities a distinct advantage over investment in stocks - you don't have to be right about the direction of the stock market! It's hard to say whether all the added liquidity will mean bull or bear in stocks; but either way, the required bailout money probably means bull for inflation and commodities. Avoidance of a bad recession would just add a little pricing power for some of the more economy sensitive commodities.
• DougM

  Mar 03 03:45 PM
  "At some point in the months ahead, these funds will begin to move back into the stock market as investors grow tired of earning a negative real return on their savings."
  
  That may be true, although today a good number of them are throwing their money into commodities.
  
  "Viewing today's markets, a strong case can be made that aggressive Fed rate cuts have been counter-productive; Fed easing has exacerbated inflationary trends in the commodity and currency markets, while doing little to prevent the repercussions of the bursting of the credit and real estate bubbles."
  
  Depends on what you think the real goal is. IMO the Fed's real goal is to prevent a collapse of the banking system. Banks borrow short and lend long, hence the stickiness of long-term rates (or the prospect of even higher rates if inflation expectations build) combined with negative real returns on bank deposits have the effect of slowly recapitalising the banks at the expense of savers. The Fed can't come right out and say they're trying to bail out the bankers that made all these bad loans because the FDIC can't possibly make good on the deposits if even one large bank goes under.
• sbenard

  Mar 04 12:13 AM

  My Website
  At one time, in Mr. Bernanke's famous 2002 helicopter speech, he boasted of the Fed's money and inflation creating ability. Now, he denies it. This suggests intentional deceit. He knows better, and so do the markets. His credibility is shot.
• beancounter

  Mar 04 07:42 AM
  Inflating your way out of this mess is no good. There are trillions in leveraged positions in the CDS sector that must be unwound, or simply, written off. Some banks, a la Grantham, must fail, including an I-bank or two. Otherwise, this has the potential for a great depression style market event. The dollar will be sacrificed until a Volcker style chairman emerges, jacks up rates, strengthens the dollar with its concomitant decline in commodity and oil prices. In the meantime does anyone know where I can get a Swiss Franc denominated CD?
• Lisa

  Mar 04 08:09 AM
  Beancounter, you can buy a Swiss Franc ETF:
  seekingalpha.com/artic...
  
• Ralph F

  Mar 04 09:01 AM
  "Government sponsored inflation ultimately affects all prices, including stocks."
  
  This is a smart article. Interestingly, inflation is good for companies with debt, bad for companies sitting on loads of cash. The value of their cash gets eroded by inflation, and the interest they receive on it plummets as the Fed cuts rates.
  
  Value investors watch out!
• ajwooley@gma
  il.com

  Mar 04 12:36 PM

  My Website
  Bernanke knows better, are they trying to make the dollar so worthless that debt evaporates? Stagflation is a serious concern this year and only investment in tech development and capital to keep productivity growing. Drop the protectionist attitudes, severely cut gov't spending, and promote national savings. We're over extended and can't afford the credit we already have.

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