Friday's Rate Cut: A Sign Things Are Really Bad

Includes: DIA, DOG, SH, SPY
by: Enzio von Pfeil

If you think that the worst is over, think again. Was last Friday's rate cut a balm - or a sign that things are really bad? We believe the latter.

1. Econ 101: what rates were cut?
The Fed cut the discount rate. This is the rate at which the Fed lends to banks for different maturities so that they can maintain their required reserve balances at the Fed. This is different to the Fed Funds rate: this is the rate that banks lend to other banks overnight at the Fed. Again, such lending is done in order for banks with excess reserves to lend to banks who do not have the required reserves with the Fed. The discount rate normally is higher than the Fed Funds rate, so expect Fed Funds to drop too. Big deal.

2. Why we remain skeptical
Once the news was out on Friday, Wall Street and thus Europe rocketed. We expect the same for Asia at least for Monday, if not for some more days. You will hear plenty of babble about Fed Funds being cut around 18th September, if not before.

So why are we skeptical? As The Economist expressed so clearly in its 18th August 2007 issue, p. 9, "Surviving the markets" (I have italicized and put the bullet points in for greater clarity):

Because this crisis taps so deeply into the newly devised structures of finance, anyone who says the worst is definitely over is either a fool or someone with a position to protect. As risk has become bewilderingly dispersed, so too has information.

• Nobody yet knows who will bear what losses from mortgages - because nobody can be sure what those loans are really worth.
• Nobody knows if tighter lending standards will oblige borrowers to raise more capital, triggering more sales in stock markets and more pain.
• Nobody knows how messy the inevitable bankruptcies will turn out to be.

What markets need now is time to piece that information back together. Time before the next wave strikes.

Crucially, the next wave will be even tighter credit markets. As one bright trader put it: the transmission mechanism has broken down. Banks may have ample funds - but they are suspicious of each other. Nobody is lending, and that is going to pervade the economy.

Thus, even if the Fed has lowered the rates that it charges when lending to banks so that they can replenish their required reserves at the Fed - that is really not the issue. The issue is that banks don't want to lend. Period. Have you ever counted the number of petunias in a desert? The number is low: there is no water!

So forget bargain hunting in Asia. While The Economic Time™ is generally excellent outside of Japan, don't risk your money. "De-coupling" is a fairy tale of fools - until the market has moved out of denial. shall we say at this early stage, perhaps in November?

How to Make Money Off This Idea
1. Always discuss instruments with your financial adviser!
2. I am tempted to buy a "short" ETF on the US market, and
3. I also am tempted to buy put options on the rating agencies: The Economist and others wonder whether these groups had conflicts of interest when rating the CDOs, so they will be in for a rough ride.
4. But the other 50% of our Economic Clock as well as Theme Fund is purring away in USD cash earning a healthy 4-5% return, just waiting....