December 2007

The "r word"

Market focus is now almost solely on the waning economy and the growing possibility of recession, the "r word." Throughout 2007, the market has been range-bound awaiting consensus. Fed Chairman, Ben Bernanke has said that the Fed's actions are data-dependent while the market appears to be near totally Fed-dependent. The dependency on weekly and monthly data gives the market a bipolar feel and a short-term perspective. Eyes are now fixed on the December 11th FOMC meeting as the markets price in the next rate cut. Stock prices are likely to remain choppy and range-bound until the financial sector of the market improves.

In late November, Mr. Bernanke indicated that another cut in interest rates may be in the offering in coming weeks. Does the Fed see something? A quote, attributed to an Italian general, might very well apply to Mr. Bernanke's situation...

"There go my men. I must follow them. For I am their leader."

If the Fed cuts the Federal funds rate by 50 basis points, or 1/2%, the rate will drop to 4%. With this cut, will the Fed be ahead or behind the curve? The current yield curve on a 10-year U.S. Treasury note is already less than 4% and yields at the shorter end of the curve are dropping even faster as money looks for a safe harbor during these turbulent times.

Over the past several months, we have noted that the discount rate remains above the Federal funds rate (by 50 basis points at this writing) and that this creates somewhat of a disincentive for banks to borrow at the "emergency" discount window. To assist in overcoming some of the current credit problems, the Fed could cut the discount rate to 100 basis points, a full percent, below the Fed funds rate. This effort alone will not fix the situation nor guarantee that banks will lend further into uncertain markets, however, it could be a foot in the right direction at a time when few attractive alternatives exist. The credit problems within the financial sector of the market are expected to continue to worsen along with the housing situation. In our opinion, only a market-led readjustment of asset values and its associated derivatives will fix the problem. We do not see a resolution to the housing problem until home prices drop to realistic levels. This process will take some time to work out and pains along the way are inevitable. One of these pains will likely include RECESSION.