Fed Flying Blind... Still
A turrnaround is possible, but damage has already been done.
Hard landing, soft landing or crash landing? The U.S. economy is akin to an airplane in distress. The Federal Open Market Committee is at the helm; one engine has definitely stalled, and they're now faced with two choices: do they gun the working engine and try to make it to the next airport, or do they go for an emergency landing in that soft-looking field nearby?
Option 1 is high risk, high reward - if successful, the passengers will be none the worse for wear; if unsuccessful, the crew loses the opportunity to land the plane under their own power. Option 2 is medium risk, medium reward. Such a landing would undoubtedly be messy, but the crew could control the landing process. Sadly, with one engine already out there is no low risk, low reward option.
The Fed chose Option 1, aggressively cutting rates and gunning the single engine in hopes of averting the recession. The problem with Option 1 is this: you cede your passengers' fates to chance. With Option 2, you might have incurred casualties, but you'd have done so on your own terms. Currently, in this market and economy, we're long past the field and are struggling along on one sputtering engine; that airport isn't even on the radar screen.
Tonight's note will sound critical, but considering how rough things were today, it's fair to explain the origins of the current environment. Most of our thoughts here are not new, and these views were expressed in previous notes as events unfolded. The Fed's first real mistake was interceding last August on behalf of Countrywide (CFC) to arrange a strategic investment. The market has already voted: Letting the company stay alive has allowed a "bad bank" to inflict serious damage on a "good bank." The second mistake was allowing financial firms to mark their positions aggressively, dragging out the writedown process.
The biggest problem Bear Stearns had was that the losses they reported were so small that nobody believed them. Remember, Bear reported smaller losses than Goldman Sachs (GS), who received accolades from the investment community for being short subprime in 2007. Again, we wind up with a market fearing the potential damage a "bad bank" can inflict upon a "good bank." You can argue that the Fed saved the market from Bear's counterparty risk - but in that case, the foundation of the market is notably weak, and we should be lower regardless.
At the moment, the market's most upset about the decision to favor growth over inflation, unleashing commodities -- notably energy commodities -- and depreciating the dollar at an even more rapid pace than that of the previous 5-year downtrend.
The aggressive easing primarily took place in the form of two 75 basis-point panic eases. The first came the day after Martin Luther King Day, following a large European sell-off when Société Générale was unwinding a rogue trader's book.
By the way, the Fed did not know that the sell-off was occurring, which is not entirely their fault. Nonetheless, it led to the single largest ease since 1984. The second ease took place the day after St. Patrick's Day, following the Bear Stearns deal. Ironically, the final ease during this cycle was one the market did not clamor for, on April 30th.
Both last month and in Congressional testimony regarding the Bear Stearns deal, the Chairman provided insight into the Fed's approach to unwinding the Bear Stearns book taken on by the New York Fed. The Fed has allowed itself 10 years to unwind the positions.
Citing Walter Bagehot's 1873 classic, Lombard Street, the Chairman noted his interpretation:
"Thus, borrowers can avoid selling securities into an illiquid market, and the potential for economic damage -- arising, for example, from the unavailability of credit for productive purposes or the inefficient liquidation of long-term investments -- is substantially reduced."
We can only speculate that the Fed has taken the same approach with financial institutions - i.e. it has allowed them to swap mortgages in exchange for cash and treasuries through term auction, term security lending, and primary dealer credit facilities rather than liquidate.
Meanwhile, despite the aggressive easing to 2% on the federal funds rate, mortgage rates have risen. The rate for a 30-year fixed-rate mortgage is within basis points of both its 2007 and 2006 highs. You need to go all the way back to 2002 for higher mortgage rates.
With essentially the highest mortgage rates in 6 years, we can only imagine what's happening to the mortgages the Fed took on from Bear - as well as the ones they're holding as collateral for the liquidity programs.
The true irony is that the aggressive easing was meant to help the "real" economy and defray an adverse outcome. That policy has backfired. The lower rates aren't being passed on to the consumer: Mortgage rates have risen, which has in turn fueled inflation fears, sending crude into the stratosphere and squeezing both consumers and corporations.
With crude sitting at the $140 level, there's no incentive to allocate additional funds to U.S. equities. At $100, the airlines really started feeling it; at $110, the automakers really started feeling it; at $130 and above, everyone really starts feeling it.
It's rare for equities to correct 10% and entice us not at all for a trading rally, but today we have a different view. The market's last two bottoms coincided with the previously mentioned 75 basis point eases. This time, equities will need to find their bottom.
One thing the equity market does not want right now is Fed easing - we would probably rally on tightening, but we'll get neither. Until crude displays a few signs of weakness (by breaking $130), or the volatility index moves notably higher, it's best to remain cautious.
Would an about-face by the Fed correct the situation? Well, it might help crude correct quicker, but the help given to the dollar would be minimal at best, and severe damage has already been done. When the Fed tightened 17 times from mid-2004 to mid-2006, it essentially halted the dollar's decline briefly, but that resumed once the Fed paused.
I believe the lower repricing of equities will be necessary to finally force the correction in crude.
Anyone making a market in parachutes?
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