Stocks Will Remain Under Pressure Until Second Fed Rate Cut

Last week’s market action provided numerous examples that the Fed is thus far accomplishing its objective of stabilizing financial markets. The S&P 500 rallied 2.3% last week to close at 1479, over 100 points above the panic lows reached on August 16. The 3-month T-Bill yield, which had plunged to 2.53% in last Monday’s session amid an historic flight to quality (and avoidance of commercial paper) in money markets, closed the week back above 4%, suggesting that the panic rush to the safety of T-Bills has run its course for now.

The "VIX" volatility index - the market’s "fear gauge," which had soared to the highest levels seen since early 2003, has retreated over 40% from its highs, but remains elevated compared to the low volatility conditions that have prevailed in recent years.

Despite these encouraging developments, it is much too soon in our judgment to conclude that the worst is over for stocks. A market bounce was to be expected following the 8% S&P 500 decline that occurred in the space of six sessions from August 9 to August 16, and the rebound has certainly been abetted by the August 17 shift in Federal Reserve policy. Technically, the market is still in a declining trend that began in mid-July; the pattern of lower highs and lower lows won’t be rectified until the S&P 500 can exceed the 1500 level.

Fundamentally, although we recognize that nothing soothes a falling stock market faster than easy monetary policy, which is now on offer from the Fed, we believe that the risks emanating from the sea-change that has occurred in credit markets remain too high to move away from the current defensive position of our portfolios. Historic credit excesses are in the process of being corrected, so we would expect this equity market decline to be more pronounced in terms of time and price than prior declines that have occurred in this bull market.

Despite the Fed’s efforts to jumpstart and re-inflate credit markets, we expect that the credit contraction and de-leveraging processes that are now at work will remain a potent headwind for asset markets for a period of time. Against this backdrop, a prudent investment approach requires the focus to remain on capital preservation.

Evidence continues to accumulate that unless financial markets improve substantially over the next three weeks, the Fed is preparing to cut the federal funds rate at its next policy meeting on September 18. Although inflation remains above the Fed’s targets, developments in the credit and mortgage markets have caused the Fed to shift its focus from inflation to "downside risks to economic growth." The Fed sent a strong message with its August 17 surprise cut in the discount rate and the change in its policy statement, which made no mention of inflation.

Moreover, Bernanke was quoted last week as saying that he "intends to use all available tools" to ease turmoil in the financial markets and head off risks to the economy. As a result of these developments, as well as the Fed’s "de facto" easing via repeated liquidity injections that have served to keep the actual fed funds rate well below the current "official" fed funds rate of 5.25%, the fed funds futures markets are now fully pricing in a quarter point cut in the fed funds rate at the September 18 meeting.

What are the likely consequences of Fed easing, and what does this reversal in Fed policy mean for investors? Eventually, stocks will respond positively to Fed rate cuts assuming that easier monetary policy is successful in cushioning the blow to the economy from credit market distress and a continued weak real estate market. However, history suggests that stocks will remain under pressure until the second Fed rate cut, as the corrective forces that prompted the monetary policy reversal in the first place run their course. The long end of the Treasury market is likely to suffer as a result of the Fed’s shift to an easier monetary stance.

Over the past two years, the Fed's emphasis on containing inflation by increasing interest rates and then maintaining a tightening bias has kept yields on longer-maturity Treasuries low relative to shorter-maturity debt. Now that the Fed’s focus has shifted from inflation-fighting to stimulating growth through monetary ease, longer-term inflation expectations are likely to rise, and investors in long-dated Treasury securities are likely to demand a higher risk premium.

The 10-Year Treasury note yield has fallen sharply since mid-June from 5.3% to 4.6% amid a flight to safety and growing concerns about economic recession. Assuming the Fed is successful in supporting the financial markets and keeping the economy on a growth path, we would expect the 10-year Treasury yield to rise back above the 5% level sometime in the fourth quarter as risk appetites return and inflation expectations rise.