Thursday, August 30, 2007

Near Term Outlook

As mentioned before, sentiment is still shaky and we need market psychology to turn positive before we see better times. Well, we are still waiting for one of two things:

a) Fed's aggressive rate cuts to lift markets, pump liquidity and/or

b) A big investor to step into the mortgage biz and bid for some stocks. Bank of America's convertible preferred bond investment is good but not good enough because the investment was too shrewd and protected BoA in more ways than one, plus they are preferred which puts them top of the heap in the event of bankruptcy by Countrywide. We need either a big hedge fund or a respected investor like Buffett to come in. In an indirect way, Buffett is involved via Berkshire's stake in Bank of America.

The markets all was shaken from the release of the minutes from a Federal Reserve meeting on August 7. The highlights:

The minutes of the August 7 meeting of the Federal Open Market Committee, released Tuesday, show it considered taking policy action to calm the credit markets but remained more concerned about inflation. "a further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response," the minutes say. However, "given expectations that the most likely outcome for the economy was continued moderate growth, the upside risks to inflation remained the most significant policy concern." At an emergency conference on August 16, the FOMC lowered the discount rate by 50 basis points to 5.75%, saying the risks to economic growth had "increased appreciably."

The markets got more uncomfortable after the release of the minutes because there appears to be a clear divergence in what is most important. The markets are trying to tell Bernanke that the Fed SHOULD NOT be looking at inflationary risk as the top priority, and that there is severe dislocation in credit markets which the Fed is only gradually recognising but not fast enough.

If you look at fed-funds futures contracts trading, they are already pricing in multiple interest-rate cuts, starting with a quarter-percentage-point reduction at the Fed's next policy meeting Sep 18. Although not a perfect predictor, the 30-day Federal funds futures contract that expires in October 2007 seems to imply a Fed funds rate of 4.90% and is currently pricing in a 100% probability that the Fed will decrease the target rate by 25 basis points to 5.00% at the September meeting. In fact there were times over the last few days that the implied Fed funds rate have gone to 4.78%, which would have mean discounting a 50 basis points cut on Sep 18.

In my view, there are two important indicators which have popped up recently which would cause the Fed to cut rates aggressively:

a) on Tuesday it showed that the U.S. consumer confidence index fell sharply in August to 105.0 from a revised high of 111.9 in July, its steepest fall since the aftermath of Hurricane Katrina in September 2005. Confidence is now at its lowest point in a year. This raises the risk for a consumer-led recession in the near term, which would then throw out Fed's extreme-fascination with inflationary risks.

b) An S&P/Case-Shiller report also released on Tuesday showed a 3.2% decline in house prices versus a year ago, their worst decline in 20 years. The housing slump is making it more difficult for consumers to use home equity to finance their spending, which represents 70% of the economy. The Fed will be aware that the decline is highly likely to continue rather than level out which could only mean more weakness ahead. Realising that rate cuts now will take at least 6-12 months to work itself into the real economy, the pressure to cut at a quicker pace has risen.

To the Fed, the one indicator which is supporting the real economy is the tight jobs market. The same CEOs calling for massive rate cuts are also hiring at a decent pace. Its the one time where many of the US companies are helped by the more robust global economy.

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