Sunday, August 19, 2007

Fed cuts the discount rate, changes it bias in a single bound.

- Fed becoming a game changer as it tries to rein in the credit issue.
- Fed cuts the discount rate, changes it bias in a single bound.
- Shades of 2000, but the Fed is on a completely different page this time.
- Short sellers grousing because the Fed did its job.
- Fed may have more of a propensity to cut now, and the key point is whether the Fed acted in time. The market will show us more on this in the weeks ahead.

Market jumps as Fed alters its stance.

The Thursday fear was pretty pregnant, and the use of 'unprecedented' in describing the credit situation sure sounded like 'it's different this time.' Sure enough the market bottomed when that view started circulating around the trading desks. From massively lower to flat or better on the close.

That was a big momentum swing, but the market was not in the mood to continue the reversal Friday morning. Futures were back in the toilet early in the day as the foreign markets were getting crushed in Asia and in Europe. The unwinding continued and the shorts were piling on, creating that powerful one-two punch that was dogging the market all week.

Then the Fed cut the discount rate 50BP to 5.75%, simultaneously issuing a statement that essentially said the Fed had changed its bias from inflation watching to worried about downside risks. Futures reversed and soared higher. When the bell rang stock prices soared as well. The Dow rallied over 330 points and NASDAQ added 74 points. Then it peaked. The sellers took their shot and drove DJ30 to just a 60 point gain and NASDAQ a measly 15 points. Then a slow, steady recovery from midmorning into the close. It did not recover all of the gains though the indices easily finished in the upper quarter of the day's range. With the Fed getting deeper into the game the shorts had to cover some more before the weekend, and thus the climb back from that early bout of post-surge selling.

Technically it was a good but not powerful session. Sure gains were in the 2% range on average for the indices, but it was not a rocket launch higher. Maybe if the Fed had cut the Fed Funds rate it would have been different. Maybe then it would have been the 'largest point gain in the history of the Dow' as Jim Cramer so forcefully predicted pre-market on CNBC after the Fed had acted. As it was it was a strong day but no massive move that definitively changed the market's character. You can infer it might given the Fed is in the game, but the action says that the market was not totally convinced that was the case.

Basically stocks rebounded from an oversold condition after 6.75 days of very nasty selling. The Fed action gave the move some extra juice out of the gates, but again, in the end it was totally convincing. Many of the materials stocks that gapped higher ended flat to lower. That still shows some fears regarding the global economy and how it will fare after the credit freeze thaws.

The Thursday session may in fact have been the bottom; the sentiment indicators were high, VIX spiked, the stink of fear was in the air, and the new replacement phrase (or actually word) 'unprecedented' made its debut in the market. Those are all signs of a bottom being put in.

Of course we have to keep our heads about us and realize that when the bottom is set that does not mean stocks automatically turn higher and never look back. When no one can stand it anymore and they sell and then the market turns. It then takes some time to completely fill in the bottom. There is still a massive global unwinding of various trades by many institutions and hedge funds, and that is not over. Thus after a bounce from the initial reversal move the market will likely undergo some more bumps as the rest of the work is done to fill in the corners.

For example, back in 2002 VIX hit its high in October and the market reversed just as it did Thursday. It was not until 4 weeks later in November, however, that the bottom was completed with its second bottom. Even after that it took until early December for the market to gap higher and breakout from the double bottom on massive volume. Interestingly, the market completed the second leg and the bottom on very low volume, taking almost everyone by surprise as many were looking for another cathartic sell off given the market failed to hold the prior bounce.

In sum, the Fed is in the game and as we discuss in further detail below, that has the potential to really change the game. The market responded on the heels of that Thursday reversal with a nice gain. That could very well have been the low. Now the market has to complete the bottom, and it still has to go through some turbulent times what with the hedge funds still having to sell to stay alive. Rarely is there a knifepoint turn, and thus many will return to negative views after this initial rebound appears to lose steam. Oh well, they will miss out, we won't.


Fed changes its bias along with the discount rate.

Friday the Fed lowered the discount rate (in addition to a few new wrinkles discussed below). The discount rate is the rate banks pay to come to the Fed and obtain funds in order to be able to conduct business when needed, maybe when times are a bit tougher. There is something of a stigma attached to it, and if it can be avoided banks do so. Indeed, the Fed, in addition to lowering the rate by 50BP to 5.75% called most banks together on a conference call and encouraged them to use it and that the Fed would think nothing bad about any bank that did.

Now some said this was just a psychological move because the discount rate is mostly symbolic. In other words the move was made to show everyone that the Fed was paying attention and doing more than throwing money out of helicopters. Indeed, the move was psychological. Anytime the Fed cuts rates it has that impact.

But this was more than just good feelings. Former Dallas Fed President McTeer noted that this was key because in the current environment no banks were dealing with each other because if they accepted some collateral that turned out to be worth less than they bargained they could be negative at the end of the day and face closure. By lowering the discount rate and telling banks not to be afraid to use it without repercussion the Fed was actively lubricating the system to get all of that liquidity it injected put to use.

In addition, the Fed changed what it would accept at the window, now including home mortgages as part of the list of instruments as collateral. That cuts to the heart of the issue. Of course it is not taking crap mortgages, just the triple A ones, but nonetheless it is taking them. Second, the Fed increased the repo time from overnight to 30 days. The Fed is really coming to the table in a bigger way than just the 50BP cut in the rate indicates on the surface.

Outside of the actions relating to the discount rate the Fed issued a statement explaining why the cut was necessary. In that statement the Fed, without formally saying it was changing its bias, did just that.


In one paragraph just two weeks after its last meeting the Fed removed its inflation bias and now stands ready to 'act as needed' to see the markets through the credit crisis. We said three weeks ago that these contagions spread fast, and this one was crawling up the steps to the Federal Reserve. That was enough to get the Fed into action, and this statement clearly lays out that the Fed is going to do what it takes to stave off an economic slowdown. That frees up the Fed to make another move at anytime. It can wait until the September 18 meeting if it can, or it can cut ahead of that if conditions warrant.

Once more Bernanke has shown he was more than just an academic. He could have hit the panic button and cut the Fed Funds rate a la Greenspan, but instead he is taking a measured but accelerating approach that is in itself helping to calm the world financial markets.

Is this 2000 and the same old Fed once again?

Many are comparing this to the 2000 meltdown. We have drawn comparisons as well, though not along the same lines many are. Our concern was the rising volatility as the market made new highs, not that the market was overvalued or the US economy was about to head into recession because the consumer was tapped out, the dollar was going to crash, etc.

Back in 1999 and early 2000 the economy was strong. The market was too strong because the Fed flooded the country with money ahead of Y2K. There was no need for it and the money went everywhere, including the stock market. In early 2000 when the 'crisis' was over, the Fed called all of the money back at once. It was yanked out of the market and every other investment it was put into. That caused an economic shudder. The market shuddered and corrected massively. The Fed then put banks on restrictive loan status so no one could get any money. After NASDAQ corrected 35% it hiked the Fed Funds rate another 50 BP, that little parting shot that helped out the economy so much. By the end of 2000 GDP growth fell from 10+% to nothing in 2 quarters. The Fed refuses to act until NASDAQ has sold off 55%.

Fast forward to a year ago. After inheriting another tightening round from Greenspan, one that allowed money supply to grow wildly even as the Fed Funds rate was cut, Bernanke continued with a couple of hikes to show there was no unsettling change in course right off the bat. Behind the scenes, however, Bernanke quickly lowered money supply, cutting the source of the inflation pressures, i.e. excess liquidity. By July the inflation pressures that started to peak in October 2005 were showing up in the data, and the Fed went on pause and has been on pause since. When the economy showed potential problems down the road by virtue of the sub-prime issue and the credit issues, the Fed started to act to solve the problem.

Let's recap. In 2000, strong economy, no inflation, Fed floods economy with liquidity, yanks it all away cold turkey. Stock market plunges in response, forecasting a recession. Fed hikes rates in March and an additional 50BP in May. Fed waits 7.5 months, realizes it has ruined everything, cuts rates. Too late. In 2006 the Bernanke Fed sees inflation slowing so it stops hiking. When it sees signs of financial gridlock it steps in to add liquidity and will continue to do so according to its statement. Greenspan hikes into an economic meltdown. Bernanke cuts rates in its first couple of months. Unlike in 2000, this current action gives the economy a chance to fight off the contagion and continue to expand. Maybe it will work, maybe it won't, but there is a big difference this time around.

Did the Fed do what it did to skewer the short sellers? Of course not.

The Fed action clearly helped the market turn higher Friday. Futures were lower Friday and then reversed after the Fed action. As in 'The Matrix Reloaded,' cause and effect. Because of that relationship, the short sellers were on the financial stations screaming about how the Fed should not rush in to 'save the markets' or 'rescue the foolish investor.' Bill Fleckenstein (short seller), Hank Greenberg (called the 'realist' on CNBC because the more appropriate descriptive titles are not PC) and others were carping that those crying for Fed intervention want it both ways, i.e. demanding free markets but then when times get tough or a crisis arises they clamor to be rescued.

There are at least a couple of problems with this logic. Now if these folks are saying we don't need a Fed at all or maybe one in substantially different form and power, I am interested. I have not heard that, however. They want a Fed as well to help curtail inflation, keep prices stable, and then let prices fall when things are not stable. In other words, they want just what they claim the others want, only in reverse. They don't want inflation eating into what they make anymore than the upside players. They don't complain when the Fed hikes rates and stalls the economy. They do complain when the Fed steps in to try and regain price and economic stability when things are selling off.

With the gridlock in the credit markets there is a serious problem confronting not only the US but the world. As discussed Thursday, the Fed is not worried at this stage about whether Fed action may benefit those lenders and investors that participated in the poorly conceived loans and investments based upon those loans, at least not as its first concern. Its primary goal is to prevent a serious economic meltdown. Once that is done it and Congress can sort out if there was any wrongdoing. As I said Thursday, no one wants to risk an economic meltdown that impacts everyone negatively just to punish a few wrongdoers. Again, that can be sorted out later.

Finally, consider the source of the complaining: short sellers getting hammered. We sold a lot of our put plays Thursday when the fear and size of the losses hit extremes for that run. The Fed is always in play when there are perceived extremes or severe stresses in the financial markets or the economy. It does not matter if it is on the upside or the downside. That is what the Fed is there for. Complaining because the Fed increased its efforts to improve credit market liquidity as some kind of effort to rescue the stock market is asinine. This current episode is not some interesting experiment for us to watch and see how it plays out either with recession or a further expansion. This is the real world. In the real world of the market you have to take the Fed into consideration and know it can and will act. In the movie 'Cliffhanger,' Rocky Mountain Rescue ranger Hal Tucker mocked his captors after one fell off the side of the mountain, saying 'Gravity's a b**ch ain't it? In the stock market, all I can say is the Fed can be a one as well for short sellers AND upside players. Thus when it is in the game, you have to take note.

By: Jon Johnson, Editor

Jon Johnson is the Editor of The Daily at

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