"Don't Fight the Fed" Takes on New Dimensions

by: Jeff Miller

The Fed announced their decision to cut the fed funds rate and the discount rate by 25 bps. The accompanying statement did not explicitly highlight economic weakness, the subject of market participants' greatest concern.

At about the same time GE (NYSE:GE) announced information about its earnings outlook. This was called "tepid" by TheStreet.com, since they said profit growth would be "at least 10%" when the expectations were for 13%. Bloomberg's report is less downbeat, pointing out that the forecast handily exceeded the recent predictions of Citigroup analyst Jeff Sprague.

CNBC had a story saying that the initial reaction was partly based upon some observers of a WebX presentation who did not see the words "at least" in the 10% forecast (we watched this, but during trading could not TIVO for an exact quote). GE rebounded from its lows, but the reaction pushed the S&P below the 1490 level that has been a battleground of technical support and resistance.

Our Reaction

This is an interesting situation. I have been in the financial business for 20 years, but before that I worked at a high level in government and was on the faculty at a major university. This defines the perspective of "A Dash" where we are eclectic in our approach. We see things from various perspectives, trying to understand the viewpoints of different players.

Market participants -- traders, pundits, and hedge fund managers -- have a very high level of confidence, necessary for the decisions they make. They are not always good at seeing things from alternative viewpoints.

Nearly all of my colleagues on RealMoney joined in criticism of the Fed, as did Jim Cramer on his television show. They see the Fed as either less intelligent than they are, less-informed, or naively academic. We disagree.

Initial Thoughts

Right after the announcement, I posted the following observations on RealMoney:

  • For a multi-year period the Fed has looked at the same data as have market participants and the public and seen more economic strength. In general, the Fed has been correct. Few thought that a soft landing could be achieved and no one would have expected economic growth at the pace of the last two quarters if they had known about energy prices and the housing/credit situation.
  • Most economists see the current economic data are consistent with Q4 growth of about 1.5%. One noted forecasting firm sees zero growth and economists now see a 40% chance of a recession in 2008. This is the reason that the Fed started cutting rates, a policy that has a lag.
  • 25 versus 50 bps today makes little policy difference. Neither does a 25 bps in the discount rate. The Fed has made it clear that discount borrowing should not carry a stigma.
  • The Fed does not have sole economic responsibility. Lowering rates does not by itself solve the housing situation. Raising the loan limits (to include jumbos) at Fannie (FNM) and Freddie (FRE) would help, as would reducing the capital surplus requirements. Bernanke has advocated both. There are qualified buyers who cannot get loans.
  • Fed members are probably amazed at the market reaction, believing that they not only did what seemed right on a policy basis but something close to market expectations.
  • Wordsmiths need to come up with synonymous phrases for "behind the curve." I am sick of it already!
  • The increased transparency of the Fed is not helping that much so far. It seems like a good idea, but the committee statements wash out much of the tone that those of us in the market would like to see.
  • Brian Gilmartin (one of my RealMoney colleagues) says the Fed is doing fine. There is evidence for this viewpoint. If one looks at a thirty-year record of the US economy, it is pretty obvious that recessions have declined in both frequency and severity, despite various economic shocks. Fed policy shares part of the credit for that. The Fed does not take responsibility for avoiding or piercing "bubbles", despite the emphasis on that criterion by many in the markets.
  • Tuesday's market reaction seems excessive. It includes the effect of the GE announcement (which may have had an erroneous element) and the technical selling from breaking support at SPX 1490, as Scott Rothbort noted in a timely fashion.

After the Close

I later posted another RealMoney piece, inserted below.

CNBC ran a Steve Liesman "breaking news" piece during their Fast Money program. Liesman reported that the market "could be misreading" that Tuesday's quarter-point rate cut represents the whole Fed response to the credit crunch. A Fed source who asked not to be named said that they are considering a range of tools to address the liquidity issue, ideas that would see the light of day "sooner rather than later."

Some will think that the Fed is trying to make up for a policy mistake. As readers can tell from my earlier post, I do not agree with that viewpoint. The Fed sees the FF rate as a tool that does not directly address the liquidity issues started by the housing and mortgage problems. We will see some other initiatives from them (long term repos? purchasing mortgage debt?) and there will be other stories like Liesman's.

Also, the first take on GE earnings growth was wrong, according to CNBC. They stated that some who saw the WebX presentation omitted the words "at least" from the 2008 outlook of 10% profit growth. The stock traded higher when some got the additional language.

I covered some short futures contracts after hours on the Liesman story. We shall see.

Conclusion and Implications

The Fed is still in the early stages of trying to achieve more transparency. The official statements read like they were written by a committee -- and they were!

The Fed took an action that met the widely-published expectations of the economic community. They were surprised by the market reaction. They did not convene another meeting to come up with more ideas. Bernanke obviously did think it wise to leak information indicating that more actions are coming, and probably soon. This was not a change in policy based upon the market move, as some will maintain. It was a continuing effort to communicate policy intentions.

Could the Fed have done better in signaling intentions? Sure. But that is not the question for investors and traders. The question is what actions they will now take and what the market reaction will be.

The old adage, "Don't fight the Fed", is taking on more dimensions in a world where they are looking for the right tools for the problem. The Fed sees interest rate cuts as a blunt instrument that does not really solve the credit crunch issues. We agree with that perspective.

We expect further articles from key journalists elaborating on possible Fed plans. It is in their interest, and that of the country, to maintain confidence, so they will act to do so.

As this becomes apparent, we expect a positive reaction in stocks and financials, rejoining the 1490 battleground that technical analysts are following.