Post Rate Cut: What Lies Ahead?

Aug.19.07 | About: SPDR S&P (SPY)

Last Sunday, this blog broached the possibility of some sort of intra-meeting move by the Fed. And then on Monday, Paul Kasriel at Northern Trust told me a cut in the discount rate would make life easier for the Fed as opposed to pumping the system via daily injections. Well, the discount cut happened, as we all know.

Say what you will about how the Fed could care less about "moral hazard," and has said "Uncle" after just a month of market melodrama by deciding to follow the typical bailout script of Big Al Greenspan - the more active participation by the Fed to try to plug the leaks in the proverbial dam is something that the bears should be very respectful of in the near term.

Any thinking individual knows the Fed can't fix the gargantuan OTC derivatives problem (especially a notional $30-TRILLION in credit default swaps) with a few rate cuts, but for the small in comparison stock market the monetary accommodation could still mean the chance for a some sort of rebound near term - provided that the extra lending money being provided can un-seize the secondary mortgage market, and the commercial paper markets.

Plus, if Barney Frank and Chuck Schumer have their way, OFHEO will soon be forced to allow Freddie Mac and Fannie Mae to take on more mortgage junk (stupid) - so you'll have some fiscal stimulus thrown into the picture to bail out the mortgage banking crooks.

With all this bailout for the financial den of thieves in mind, the S&P 500 200-day moving average at 1454 will likely be broken soon. It will be important to wait and see what happens at the 200 day, and whether the market came make a run to 1500, the 50 DMA. I sure think that a retest of 1375 area will be retested, but 'when' will be a function of how much the monetary, and potential fiscal stimulus (our tax dollars) can lift the market.

With discount rate cut by 50 basis points, and 90 treasury paper trading at the wide spread it is versus the Fed funds rate - there's no doubt the Fed is on its way to an overnight bank lending rate ease in September of at least a quarter-point, and another (thank you, Sir!) in October. There will probably more as it becomes apparent that consumer, and corporate consumption has caved in the face of adverse financing conditions (eventual recession). It would not surprise me to see another cut of 25 BPS in the discount rate before the September 18th meeting as a precursor to eventually getting Fed Funds down to at least 4.75% over the next few Fed meetings. Inflation lip service be damned. At the end of the day, the Fed and its other world counterparts will do anything, and everything to keep the OTC derivatives bubble from popping.

It's a shame and ominously noteworthy that the Fed has taken these actions after only a month of bloodletting. The big danger is that the Fed will empty its quiver too soon and will be out of options when the you-know-what really hits the fan, when the Fed will have to contend with both liquidity and insolvency issues, as well as to dollar weakness, and economic malaise later in the year and early next year. Over the longer term, the outlook doesn't look good for that fan that will get hit, and be knocked squarely off the table, or for the stock market, or for that matter, much of anything else but gold.

Bernanke & Co., not only addressed liquidity in a minor way relative to the real problems out there, but also market sentiment. The discount cut will be studied for years to come. Perhaps it should be investigated as well since folks seem to get wind of something big coming late Thursday as the market rallied 300 Dow points off the low.

By instituting the rate cut before the market opened on an expiration Friday, similar to 1998 (though this scenario the Fed is dealing with is unprecedented and nothing like 1998) the Fed managed to send quite a message to the shorts. With S&P (NYSEARCA:SPY), S&P 500 (SPX), OEX puts and short calls open interest into the 7 figures, Bernanke re-balanced the scales a bit by destroying a good bunch of shorts on Friday morning. That evened the score a little versus the large number of bulls who had suffered over the last month. The first thing I thought of when I heard about the discount rate cut was 'wow, what a disaster for anyone short S&P futures, or holding a ton of puts.' On margin, a 30 point move the wrong way means instant annihilation.

This attempt to even the score by inflicting pain on the previously giddy bears will make for interesting trading going forward. Who will be more gun shy after the severe whipsaws of the last three weeks? Will the shorts take it easier this time around, the bulls - or both? Perhaps with psychology so damaged and whipsawed on both sides we will see a modicum of restraint by the bulls and bears leading to a little less volatility?? Probably not, but the VIX holding to about 30 after the Friday rally is statement unto itself about the shell shocked investment landscape.

The coming days won't mean a return to smooth sailing.