A 50 Point Cut Won't Necessarily Equal Market Gains

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 |  Includes: DIA, QQQ, SPY, XLF
by: Eben Esterhuizen

There isn't a clear consensus on the FOMC rate decision, but most observers think the Fed will cut interest rates by 50bps. Of the 86 economists polled, 49 expect a 50bps cut, 23 expect a 25bps cut, while 13 expect rates to be left unchanged (the one remaining economist believes that there will be a 75bps rate cut). The U.S. short end is pricing in a very high probability of a 50bps rate cut, and Bernanke probably doesn't have the credibility to take on odds like that. "The Fed is still going to do a 50 basis points rate cut," said Michael Darda at MKM Partners. "I don't think they're going to run the risk of disappointing what they believe are very fragile credit markets."

So, let's assume the Fed cuts by 50bps. How will the market communicate a belief that the Fed is getting ahead of the curve? A useful indicator may be EUR/USD. "Investors are starting to ask whether central banks that proactively cut rates to bolster growth will now see their currencies rally and whether those that don't (will) see their currencies weaken," said UBS in a recent note to clients. This trend may already be evident in the price action of the greenback in the aftermath of last week's emergency rate cut.

The Fed's emergency cut of 75bps didn't lead to sustained USD weakness, perhaps a sign that the worst is close to being priced in for the greenback? The same can't be said for the EUR, and several analysts suggest that the EUR still has to price in a big chunk of bad news. Will we see more and more growth investors moving away from the EUR?

The latest round of wage negotiations in Germany has limited the ECB's ability to maneuver monetary policy. The major unions managed to negotiate solid increases in pay. The increased spending power in Germany may force the ECB to leave rates on hold for longer than they would like, in order to contain inflation. The longer the ECB remains on hold, the greater the damage to growth, and growth investors may shun the EUR, especially considering how heavy the currency looks after EUR/USD rallied 20% over the past two years.

In summary, if the Fed cuts by 50bps and EUR/USD remains relatively steady, it may be a sign that investors are shifting focus to growth, looking beyond the "interest rate differential" issue. This could be a significant indicator for those investors trying to find a bottom for the USD.

The other big question the market may ask after the Fed's aggressive rate cuts over the last week: Is the Fed running out of ammunition? Legendary investor George Soros recently argued that we are in the midst of the worst market crisis in 60 years. He said: "If federal funds were lowered beyond a certain point...the ability of the Fed to stimulate the economy comes to an end." Where is that point? George Soros didn't want to say, but he probably feels it is getting very close. Maybe at or slightly below 3%?

We will have to wait until the end of February to decide whether the Fed has run out of ammunition, when the full effects of the credit crunch will be revealed. By the end of February the leading financial institutions around the world would have reported their year-end results. "In doing this they were certain to announce big write-offs and huge capital-raising operations to repair their balance-sheets after the damage done by the sub-prime crisis," said Anatoly Kaletsky, a columnist at The Times.

Also, it's not a certainty that lower interest rates will automatically lead to stock market gains. "Flow follows performance," said Charles Biderman of Trimtabs.com. "Also has always will. If stocks go down, money will leave equities, even if interest rate is zero. Japanese investors ignored Japanese stocks for a decade even as Japanese interest rates hovered around 1%." With the mortgage market in tatters, will there be enough pricing power to push stock markets higher?