Fed Rate Cut Could Prop Up Housing Market

by: Dan Carty

A few yeas ago, when JP Morgan (NYSE:JPM) was collapsing into the abyss on the back of its rising loan loss provisions, I did a study to see if this financial metric was a reliable driver of the banks.

The conclusion at the time showed that the loan loss provision was driving each of the names in the banking sector lower – except for those stocks that were not showing a rising loan loss provision like Bank of America (NYSE:BAC). In addition to the banks falling, the dollar was doing the same as investors fled the greenback seeing that net interest margins were falling as the Fed cut overnight rates and growth was not responding (which means the loan loss provision would extend).

This contributed to the dive in stocks during that summer and again in the fall. When the provisions could not get any worse, around the lows in October, the market began to rally.

Meanwhile, the dollar continued to fall as the bears saw an easy one way trade and problematic general debt issues to support their story. The bears saw very limited economic growth, low interest rates and a very easy Fed – thus arrived the carry trade using the dollar.

When things began to improve and the Fed was set to begin hiking in late 2004, the dollar found some footing though it would not bottom till the end of the year. In short, when the debt markets were stable in the US, the currency tended to remain stable – not necessarily rally – but remained stable.

So what does the latest dive mean? Well, the subprime issues are hitting the marketplace. The dollar bulls are running for the hills as those who cannot afford the rising rates are defaulting on their properties, creating more bond issues. Interestingly, last week I mentioned that the dollar could find support if the Fed were to cut rates.

Given the rise in delinquency rates, I think a cut would be even more beneficial as it would support those who are having payment issues and at the same time, perhaps support CPI/inflation levels 6 months out (which I think are now moving lower contrary to the lagging CPI and PPI data we had last week).

So I am again arguing the same point again as last week with a twist: If the Fed cuts, it puts some stability into the lower end of the housing market. At the same time, it gives growth a push and helps the banks whose loan loss provisions stand at pretty low overall levels, from raising those loan loss provisions which in turn cuts into earnings.

Since the banks are a large weight in the S&P, a cut in earnings could be very problematic for the equity markets driving stocks lower. This could lead to a collapse in the dollar and a replay of the 2001 to 2004 period.

So while a .25% cut will not be the “end all be all” for those with debt problems, it will slow the problems a bit. I think slowing the problem is better than letting it collapse…which is what the Fed is currently doing. I think the Fed should cut rates modestly to 5% and hold right there. That level currently supports rising growth, stable prices and a stable dollar.