Is the Market Misreading the Fed?

I am in total disbelief that the talking heads, hedge funds, and powers that be are betting so much on the Fed cutting here (even 25bp) despite their past move being 50bp. The FOMC executed their last cut after a dismal jobs report, and during commercial paper crisis which resulted in a flight to 90 day bills not seen since the crash of 87!What's different now? We aren't in a credit crisis anymore. The commercial paper market, despite not being what it once was, stabilized somewhat. The unknowns of subprime asset writedowns are much more known than before (despite being worth 18 cents on the dollar versus 38-42 cents at mid-August).

Here's a chart of the ABX BBB 07-01 price courtesy of markit.com.

The oil, gold, and currency wildcard [essentially the USD index] is what I perceive to be the key issue here. The currency and particularly the oil/gold markets are testing Bernanke in a way he hasn't been tested before. And honestly, I don't think the Fed has showed its hand yet.

This meeting is key - I think its the most important in determining the direction of the dollar from here on out. Friday, China was putting rations on diesel fuel due to the high cost of oil and inefficiencies from refineries.

In an effort to relieve their fuel input costs as the US dollar's buying power continues to weaken, might the Chinese be motivated to quickly strengthen their currency so they have more buying power in the oil markets? The ramifications of that are pretty obvious with logical deduction: higher cost of imported goods from China (thus an inflationary pressure, economic slowdown).

Furthermore an accelerated dumping of the dollar will likely result in a flight away from long bonds, thus higher interest rates for business and individuals (for mortgages) The Fed knows this too. While the bond market is being supported at the moment by a 'flight to quality' and preoccupation with predicting a final destination for the short end of the curve, there likely will be a turning point when logic will prevail and people will not be willing to receive 4%-4.5% for 10-30yr notes/bonds amidst a re-accelerating environment of inflation.

I find it impossible to believe the Fed is not considering dollar weakness as a predominant inflationary pressure that will backfire on its policy making. Even Ron Paul's rant on dollar weakness and grilling of Bernanke in recent congressional testimony resulted in Bernanke's admittance of this obvious fact. (The video is here).

Furthermore, the seasonal weakness in crack spreads is providing an obvious buffer where oil-induced inflation will not show its ugliest head until next spring. Is the market willing to assume the Fed will wait to react instead of preempt a move in CPI data that may not show until 2-4 months? The credit markets are stabilized enough to basic functionality (the Fed's own purported goal in cutting 50bp) and there is NOTHING that 50bp did to support the price of subprime tranches. Why would further rate cuts do anything more? Subprime tranches are down 50% since they cut 50bp!

If $90+ oil is here to stay, we're only at the beginning of the food commodities rally. Watch corn go to $6.00/bu, soy to $13.00, and forced out wheat acres will repeat this past season's ascent to an even more ridiculous level. Then comes the more expensive to feed pigs, cattle, and resulting milk.

I'm not sure of an equity prognosis (I will be lightening up considerably on my position longs), but I'm short Fed funds here at 95.5 November.

Can someone tell me, in the light of all of this, besides some temporary equities market exuberance, what are the benefits of cutting 25bp or 50bp here? I simply cannot find one.

Comments

[James Cullen:]

The benefits? Try "some temporary equities market exuberance."
Just because you can think more than three months out, doesn't mean others do.

Good article.

2007 Oct 29 01:10 PM

[Accrued Int...:]

I have to disagree. Bernanke believes the Depression was a monetary event. He won't allow even a sliver of a chance that illiquidity cause a major bank failure. He's going to keep cutting until banks are earning their way through the crisis through carry. Mark my words.

2007 Oct 29 05:33 PM

[kdo:]

And he'd (Bernanke) be right, thus you will be too.

2007 Oct 30 06:00 PM

[Accrued Int...:]

I have to disagree. Bernanke believes the Depression was a monetary event. He won't allow even a sliver of a chance that illiquidity cause a major bank failure. He's going to keep cutting until banks are earning their way through the crisis through carry. Mark my words.

2007 Oct 29 05:33 PM

[Fabio De Ga...:]

I agree with you, infact since last cut we have much weaker dollar, risky assets higher, and rate for mortgage not so different from early september. The effect is asset reflation. From my point of view as a trader i have my own position in put on eurodollar december 95.25, small cost but potentially great reward if we're right. Think that market prices a 10% chance of a 50 b.p. cut!!!!!
Bernanke can be an hostage of investments banks (or probably he's yet) !!!

2007 Oct 30 07:05 AM

[David Roskoph:]

Does anyone consider us as a mirror of the Japanese Deflationary Decade? We are trying to shore up our financial house of cards and oil is taking the plac of the Fed as a growth medium. Although inflation and deflation start as polar opposites, inflation runs into deflation if pushed to a pop. There's enough complacency and belief in Fed pixie dust to usher that reality in now.

2007 Oct 30 02:34 PM

[Sr. Pessimist:]

Yep. Keep cutting until he's paying people to take out loans. Free money in the bank. If the banks die off, so do all current power strongholds in the US, the reigning interests of policy themselves.

Got an observation- looks like we've passed that critical point with currency. The debt won't go away ($9.1 T or so), China wants more energy that the US is desperately hogging up, oil has passed the unsustainable $3 a gallon point (which is the crux of the $12 T economy), the US Dollar cannot depreciate as it has and allow for continued cheap imports, the world is decoupling from the US more successfully than in 2001-3, and the cost of living is beginning to literally make some workers hungry.

I've already given up on the US Dollar. It's only a matter of time. The oversized upper class of the United States needs to all put a resume on Monster.com. World domination by the US has only served the upper class here. Most everybody else won't be affected by the collapse of the buck. Just continue working, but use a new currency, instead of living off the illegitimacy of an old one.

2007 Oct 30 05:11 PM

[FIG trader_:]

Sitting in my bathrobe on a stool here in my island kitchen sipping coffee, and the best I can say is yep. It will probably be 50. whats a few more cents to the dollars demise. And if it is 25, it will make a difference to a few thousand gamblers/traders. Everything we are basing our predictions is in the past, but the ultimate impact is based on what happens in the future; Who knows what the collective actions of 300 millions of Americans and the impact on multi-trillion dollar economy will be? Did they (you) know what would happen when they were lowering (or raising) rates the first time? Its a game, and the closer you are to the inner circle, the sooner you will find out though that doesn't guarantee you success trading. To the latter writer, world domination by Wall Street doesn't serve only the US upper class, but increasingly the elite around the world. The sick thing is that not only are working stiffs supporting the trust funds of rich Americans, but increasingly their taxes are going to pay pensions of middle class Europeans and Asians

2007 Oct 30 08:56 PM

[richrf:]

The Fed and Bernanke aren't doing anything other than printing money. They people who are paying for all of this speculative exuberance and outright gambling are the savers in this country who are forced to except lower rates in order to pay for financial games of the money managers. They take home the bonuses, while those on fixed-income are taking a beating. Democrats are now favored over Republicans by 20%, according to the latest Gallup poll, for better managing the economy for ordinary folks. The biggest gap since the 1960s. Enough is enough. The top 1% are obese with money as the middle-class savers are being thrown into the fire. This upper-class party is coming to an end as of the next election.

2007 Oct 31 10:58 AM

[irondoor91:]

What do you suggest as a remedy to an undefined problem? The size of your neigbor's bank account, house, automobile, etc. are his business, not yours. The challenge of those "savers" is figuring out a way to improve their own situation, and pulling their neighbor down doesn't pull them up. The issue isn't the "savers", as they have done good work to have saved anything in this society that demands that you spend it all even before you get it.

Anyone who has spent time with the "great unwashed classes" knows that if you confiscated all the wealth of the "top 1% obese" and distributed it among the Dems favorites in the inner city jungles, the money would be back in the pockets of its righful owners within a year. But wouldn't that be a great experiment to watch.

2007 Oct 31 11:39 AM

[Gerald:]

Could Bernanke be skillful enough to cut the discount rate by 25bps instead of the fed fund rate? This would confuse the financial markets in an amusing way: he would be meeting the market half way so to speak. It would bring rate relief to those with mortgages yet it would force the banks to continue to be responsible for proper credit assessment. We will be in suspense until this afternoon.

2007 Oct 31 11:52 AM

[Gerald:]

Could Bernanke be skillful enough to cut the discount rate by 25bps instead of the fed fund rate? This would confuse the financial markets in an amusing way: he would be meeting the market half way so to speak. It would bring rate relief to those with mortgages yet it would force the banks to continue to be responsible for proper credit assessment. We will be in suspense until this afternoon.

2007 Oct 31 11:55 AM

[Gerald:]

Could Bernanke be skillful enough to cut the discount rate by 25bps instead of the fed fund rate? This would confuse the financial markets in an amusing way: he would be meeting the market half way so to speak. It would bring rate relief to those with mortgages yet it would force the banks to continue to be responsible for proper credit assessment. We will be in suspense until this afternoon.

2007 Oct 31 11:55 AM