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Rate Cuts: Too Much or Not Enough?


Opposing views on recent Fed action.

At no other time in the past quarter century has the Federal Reserve been more aggressive in cutting interest rates. Instead of offering the markets tiny 25bp morsels like some of its G-10 counterparts, the Fed has served up whopping platefuls of 50bp and 75bp cuts at one time. Are the U.S. monetary policy makers overstuffing the capital markets or keeping them hungry for more? We take up the debate in this week's column.

We Need More

The Fed needs to bring interest rates down to 1% because these little band-aids just aren't good enough. I know you'll argue with me that 75bp is hardly "little," but has that stopped the stock market from resuming its slide? Has it encouraged banks to lend? Has it reduced the risk of another Bear Stearns (BSC)? Has it stopped traders from pricing in at least another 50bp of easing over the next three months?

No. The U.S. economy and the U.S. financial system are flush with problems. The biggest of which is risk aversion. The fear of counterparty risk is single handedly driving the liquidity crunch. The Federal Reserve needs to solve this problem and solve it fast because rate cuts alone will not be enough. I actually believe that the Fed under-delivered on Tuesday because it wants to leave the door open for an intermeeting rate cut in case another bank on Wall Street blows up.

Way Too Much

You've got to be kidding me. In the past three months the Fed lowered interest rates from 4.25% to 2.25%, making the cost of capital 50% cheaper! What good has it done? None. It hasn't stimulated the economy one bit. If anything, every gauge of growth that we have shows weaker performance.

From the manufacturers who comprise Empire and Philly to the consumers who answer the University of Michigan survey to the good old Non-Farm payrolls the U.S. economy shows nothing but a recession on the horizon. On the other hand, the Fed's policy has done plenty of harm. Have you bought a gallon of milk lately or filled up at the pump? Heck, we don't have to go any further than the coffee cart in front of our office building to realize that inflation is out of control. That's the result of low interest rates, which has made the U.S. dollar worth less than a roll of Charmin and just about as useful.

The Fed Needs to Act

And that is why the Fed's job is so difficult. High inflation is just as much of a problem as weak growth, but I still believe that growth is the U.S. central bank's number one problem. Non-farm payrolls should continue to drop in the coming banks. It's estimated that in the banking sector alone jobs could be cut by 15%. I'm actually looking for far worse numbers. Earlier this month I called for non-farm payrolls to drop by 100k and if you exclude the government jobs added last month, private sector payrolls dropped 101k. Job growth and consumer spending should continue to fall, which will force the Fed to take more action. That's why I expect the U.S. dollar to weaken and am still aiming for 1.62 in the EURUSD and 95 in USDJPY.

It Won't Help

Listen, it doesn't matter what the Fed does. The bottom line is that the U.S. has too much debt in its society. No matter how low rates will go, no one will borrow anymore. Americans need to work off their current obligations. For the next few years consumption will be out and debt reduction will be in. In such an environment, there are no incentives you can offer that will make people borrow or spend. But even if you did, there is absolutely no evidence that Fed's cuts have had any meaningful impact on the consumer. Not when mortgage rates remain above 6% and credit card debt can reach loan shark-like 25% rates per year.

Business First

Businesses will spend first and consumers will follow. At 1% interest rates, companies that have money parked on the sidelines will come out and spend. They'll want to take out loans, lock in the low interest rates, etc. Of course, banks will first have to be willing to lend. Nonetheless, once capital expenditures increase, this should help to rev up the U.S. economic engine.

Bite the Bullet

The Fed just needs to bite the bullet. It should raise rates to protect the dollar and just accept that U.S. will need to go through a pretty rough recession. Many financial firms and individuals will go bankrupt, but if we amend the idiotic bankruptcy law, it doesn't mean that they will have to be debt slaves for the rest of their lives. Once we work through the excesses in the system, the U.S. economy will emerge stronger than ever. On the other hand, if they pursue this path, we'll just turn into Japan – a moribund economy that can't seem to get out of its own way.

The Last Thing

Raise interest rates? That is the last thing that the Fed will do. A weaker dollar is exactly what it wants because it helps boost exports and draw in foreign investors looking for value plays. At some point, the U.S. will be so cheap that even people with money stuffed under their mattresses will want to dip their toes in the water. A rate hike will reverse all of the Fed's efforts over the past few months.

Where Are the Currency Plays?

I would stay short U.S. dollars for the time being. Don't expect the Europeans to step in anytime soon. The European Central Bank is worried about sharp and excessive moves, but it has its eyes peeled for 1.60. As long as we hold below that price level, I don't expect any verbal intervention because, in 2004, the EUR/USD rallied 13% in two months before the ECB called the move brutal. If we count 1.59 as the high today, the EUR/USD has only appreciated 10% over the last two months. The ECB's top priority is inflation and the strong Euro is cushioning the pain on high commodity prices.

Someone asked me when this relentless rate cutting will end. Only half-jokingly I replied it would end when USDJPY becomes carry the other way. As flippant as that may sound, USDCHF is already carry the other way and that means the greenback will continue to get no respect. The bottom line is that in the currency market he who pays interest attracts interest. As dollar rates continue to shrink, so will the greenback. The only thing that will save it from total destruction is if the rest of the world follows the U.S. on the road to recession, but for now the dollar's path of least resistance is down.

What Does This Mean for My Stock Positions?

I continue to like my RTH short. Contrary to popular opinion, low rates will not bail us out this time. The consumer is done, especially after the Fed has fanned the fires of inflation, leaving no room for discretionary spending. As U.S. consumers turn to things like dog food instead of Dolce & Gabbana, retailers are going to feel the pain.

All I have to say is be careful. I would not be buying stocks here.
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