The Last Fed Rate Cut?

For the past few months, I have been making the obvious clear. The FOMC is not cutting rates to spur economic activity.  Instead, the FOMC is cutting rates to alleviate the strain on the banking system as it relates to mortgage defaults.  Lowering interest rates dampens the impact of adjustable rate mortgages and lessens the pressure on the banking system.  The lower rates are, the less strain on the system.

The recent financial meltdown required drastic action.  However, that action may soon be reversed out of the market.  These same absurdly low interest rates have caused serious problems in the past, and private equity interest is beginning to resurface again.

This time, however, the FOMC can anticipate abuses of cheap money, and comfortably increase rates at some point without adversely impacting the banking system.  ARM adjustments, after all, are falling off a cliff as we move into the 4th quarter.  Review the chart below to understand the significant positive impact of these changes going into 2009:

The chart above suggests that the number of ARMs decline measurably in the 4th quarter of 2008.  The FOMC has made money cheap to soften current ARM adjustments, but that cheap money environment is not required for the months that lie ahead, going into 2009.

Therefore, if my premise is correct, that rates are indeed being cut to alleviate the strain on the banking system, then when ARM adjustments indeed wane, the FOMC will likely be compelled to retrace some of the recent cuts in interest rates.  If that happens, the easing cycle will have ended.  This, in turn, would make the recent cut the last and therefore an extremely positive catalyst for the stock market.  The positive catalysts will hold until the next easing cycle begins. 

Comments

[bearfund:]

Looks to me more like a 6-9 month reprieve before the Option ARM recasts kick in. Those are vastly worse than any others because their LTVs at recast are typically going to be north of 150% and in some cases probably over 200%. The possibility of a near-total loss of the bank's original investments in this space is very real. That leads to the fairly obvious conclusion that the Fed and Treasury are trying to fatten up banks' balance sheets as much in preparation for the next round of disasters as in reaction to the previous one. True, option ARM exposure is likely to be more limited than subprime was, but we've seen that contagion is likely nonetheless. The failure of a large number of smaller, less prudent banks is sure to have some systemic effect. Just what that effect will be and whether another year of negative real interest rates will offset it remain to be seen.

2008 Oct 30 10:59 AM

[Moon Kil Woong:]

Even low interest ARMs aren't cheap if the people who bought them have no jobs. And why did they buy ARMs? Because they don't have the credit to actually pay a regular mortgage or they are speculating in hopes of dumping it if their investment drops below the price they paid. The fact anyone is still writing it shows the fact that dispite all the regulation rehtoric, so far nothing has been done to prevent predatory lending, regulate derivatives, or demand collateral for CDS or CDOs. The great mortgage derivative money ponzi game with the taxpayers as losers goes on.

2008 Oct 30 02:20 PM