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Sorry to be a party pooper, but I don't buy the sustainability of the recent market rally. 500+ points in two days? Give me a break. Market prognostication is not one of my specialties but I simply have to speak.

It doesn't take a rocket scientist or the Amazing Kreskin to see that things suck out there. In the real economy. Being excited about lower rates is only part of the equation. Sure, you are discounting back future cash flows at lower rates and therefore increasing the present value, but what exactly are you present valuing?

I'll tell you what - lower future cash flows. So many market participants get all excited about the prospect of the Fed dropping rates, but I think a few questions need to be asked:

  1. Why are they dropping rates, and what are they seeing that we aren't?
  2. Does the Fed really have the power to stimulate growth simply by monkeying with the short end of the yield curve?
  3. What are the knock-on effects of the Fed lowering rates that could work against a rosy outcome, i.e., a weaker dollar that chokes off domestic demand and causes long-term rates to rise?

I personally don't like the answer to any of these questions right now. The Fed is scared, that's for sure. They see the dislocation in the credit market persisting, and perhaps getting worse. All we need is the failure of a single monoline insurer or (another) 10-figure write-down by a major bank to toss the financial markets into a complete panic, which would be good for precisely nobody (except perhaps Bill Ackman, Jim Chanos and a few others).

So in light of these risks, they may well tilt towards an accommodative stance. However, if they do this, will this really stimulate growth in the real economy and meaningfully loosen up tight credit markets? Debatable.

There are likely more direct steps they could take to provide banks and other financial intermediaries with the liquidity to bridge the gap and to address the tightness in the mortgage markets, steps that maybe wouldn't have such an adverse effect upon the dollar. And what if they continue to push down short term rates, and the real economy doesn't react as hoped?

In the absence of real growth and in light of lower rates, the dollar will fall further, only exacerbating an already difficult situation. This could have the effect of causing foreign capital to flee and long rates to rise, making it more costly for firms to raise stable, long-term capital (not to mention the US Government).

So market rallies are great, and I am an optimistic person in general, but the trading action of the last few days doesn't fool me. I just saw a dead cat bounce. And it will soon fall back to earth.

Source: Did I Just See a Dead Cat Bounce?