Taking stock of financial markets and the FED

Before mid September when the FED shaved off 50 bp from its fed funds target the DOW stood at 13404.42 (9/17/2007). After its September meeting, and as one would expect, stock prices began to climb. They in fact rose quite rapidly, reaching a peak in early October when the DOW hit 14164.53 (10/9/2007). The situation just as quickly changed however. Between the 9th and the 19th some 85% of the 5.7% climb in stock prices was lost. In short, on the 19th the DOW was only a fraction of a percentage point above where it had been prior to September 18th. The only thing that changed this was the growing anticipation of the .25% rate cut in the fed funds rate. As a result of this we have seen a healthy increase in stock prices in the last few weeks. (To see what has happened to the DOW over the last six months click here and choose zoom 6m) However, with the actual announcement on Wednesday that this was indeed what the FED was going to do we see a drop in prices rather than the sort of dramatic increase in stock prices that took place between September 18th and October 9th. Two questions immediately present themselves: (1) what accounts for the very different reaction to Fed rate cuts and (2) what can or should the Fed do about it? As the late John Kenneth Galbraith in his book the Great Crash "Of all the weapons in the Federal Reserve Arsenal, words were the most unpredicatable in their consequences" (JKG, The Great Crash, p. 38). Along with their announced cut the Fed pointedly noted that they now regarded the risks of inflation to be as important as the risks of recession. One interpretation of this, don't expect further rate cuts any time soon. One might charitably think that this was a more than reasonable statement to make, especially in light of what the figures for real income growth (the real GDP stats) for the third quarter of 2007 indicated. They showed a very robust economy, despite weakness in the housing sector with the demand for our exports growing at a much faster clip in the third quarter than in the second (16.2% versus 7.5), federal government spending growing at a slightly faster rate, investment in equipment and software continuing to grow, consumer spending growing at over twice the rate that it had in the second quarter and so on. However the weakness in housing is very real, with residential fixed investment falling 20.1% after already having dropped by 11.9% in the second quarter. Perhaps more significant is that nonresidential fixed investment grew at a slower pace than it had in the second quarter. Also over a third of a percentage point in the 3.9% growth in real income and production last quarter was due to a substantial build up in inventories. Part of this build up must be in anticipation of growing demand. As a result, continued growth in demand is a necessity if this build up of inventories is to be justified. Of course, another part of the build up could be due (and probably is due) to the weakness in housing and the softening of nonresidential fixed investment. In hindsight, it might have been better if the Fed had reported that it was still more concerned about economic weakness than inflation because as Galbraith suggested what the Fed says has very unpredicatable effects. All it took were the words that it was as concerned about inflation as it was about recession to short-circuit what arguably was one of its chief reason for cutting interest rates, to soothe financial investors' fears. Whether you believe that the Fed will have any reason to raise rates some time in the near future does not mean that you will continue to hold stock. The fundamentals matter far less than what you believe others -rightly or wrongly- think and how they will react. If you think a sufficiently large number of your fellow traders are likely to be bears then you have no choice but to follow suit (unless you can wait things out a bit) It did not help matters at all that the price of oil went higher as buyers in the oil market factored in growth in overall demand in the U.S. market. (They of course failed to factor in the impact in turn of significant oil price increases on that growth.) This undoubtedly added fuel to the speculation that either the Fed would indeed refrain from further rate cuts (and possibly in fact raise rates) or at least to an increasing belief that others trading stocks felt this way. Others then would be less inclined to hold stock, penalize those who failed to follow suit, and thus depressed the market still further What has been encouraging and characteristic of the fed funds futures market is that until this morning's jobs report traders were still betting strongly on another quarter percentage point rate cut in December and more than even odds of yet another cut of .25% in the targeted rate in January. However with the jobs report, an unemployment rate still at 4.7% but growth in payroll double the consensus estimate, these estimates have changed, especially in the case of another 25 bp cut in December. The probability of a .25% cut in the targeted rate implied by the price of these contracts has fallen from a 84% probability to only a 68% chance. (for more on this market click here.) Still I think the point to emphasize is that as of now it remains true that the majority in this market still believe that it is more than likely the Fed is going to be cutting another .25% off the fed funds target by mid December and still more than even odds that it will target still lower rates in January. This is regardless of what the Fed might have wished to suggest on Wednesday The added liquidity to help struggling banks that recklessly overextended themselves is there but the Fed must also take the reaction of financial markets into account. The simple fact is that if banks fail or capital markets seize up then the final quarter of 2007 and the first quarter of 2008 will not be as strong as they could be, whatever strengths we saw in the U.S. economy during the third quarter. One might argue that the credibility of the Fed -having suggested that further rate cuts should not be expected- is in danger if it does indeed cut rates further. The Fed did not however categorically state that it was not going to further cut rates. Also, it is fortunate that most involved are wise enough to realize that even if the Fed had made such a foolish and categorical statement at the end of October concerning its plans a month and half later that this is subject to change.