By The Curmudgeon
The Fed’s discount rate cut and massive injection of liquidity into the banking system has temporarily stabilized most financial markets (high yield municipal bonds appear to be a glaring exception). Fed Fund futures are predicting a 100% probability of a rate cut at the Fed’s September 18th meeting. The 2 and 3 year Treasury Notes are yielding 4.29%, which projects over 100 basis points of Fed Fund rate cuts over the next year. The 5 year Treasury Note yield -at 4.41%- is incredibly low compared to the current headline inflation rate and Fed Funds rate. More rate cuts are probably factored into that low rate. If not, how could investors be so dumb to buy those notes instead of rolling over T bills or (non mortgage backed) Commercial Paper which yields so much higher?
The tendency of former Fed chief Alan Greenspan to bail out financial markets has become known as the “Greenspan put.” Now that Ben Bernanke is at the helm, it has generically been dubbed the “Fed put.” The Fed wants to avoid a recession at all costs- even if it bails out mortgage lenders, hedge funds, banks, and other financial institutions. Cutting the Fed Funds rate, with inflation above its target rate of 3% is not warranted if the Fed’s primary concern (as stated in many meeting minutes) is inflation. It is clearly and unabashedly a bailout. What no one knows is at what low level do stocks, corporate, or municipal bonds have to drop to trigger a Fed Funds rate cut and whether the actual cut will be 25 or 50 basis points per meeting. That is, what is the strike price of the Fed put and which markets are the Fed governors watching?
PIMCO’s Paul McCulley (whom we greatly respect) believes that there will be 100 basis points of Fed Fund rate cuts over the next six to 12 months, with a 50 basis point cut at the Fed’s September meeting. We are not so sure that Bernanke will cave in to the pressure, particularly if stock and bonds markets remain calm.
Many believe that Bernanke does not care about the value of the US dollar (remember his earlier remark about printing dollars and dropping them from a helicopter?) and so he will continue to cut rates even if the dollar falls. And it certainly would if real rate differentials narrow with respect to the Euro and GBP short- term rates.
What the “Helicopter Ben” pundits miss is that if the dollar falls too far or too fast, then foreign central banks and corporations will be very unlikely to buy US Treasury Notes and Bonds. If they don’t then who will finance our debt? Answer: NO ONE. In that case, interest rates would soar, further depressing the housing market and completely stopping debt based financing of all kinds (LBOs, mergers and acquisitions, corporate expansion, etc.). The result would definitely be a serious recession. Hence, large Fed Funds rate cuts would be counter-productive, because they would result in the recession the Fed was trying to avoid by cutting rates!
We believe that Bernanke does, in fact, recognize the box he is in and will be reluctant to cut rates too fast or too much. Hence, Treasury note yields are way too low- unless they are correct in discounting a much lower inflation rate in the future then we believe will be the case (note that if the Fed cuts rates, a weak dollar will put strong upward pressure on US inflation rates).
Now lets turn to stocks. We believe that corporate profits are unsustainable and are peaking- probably in the current quarter. Profits are likely to fall in the coming years. When this is accepted, large institutional investors will probably realize that stock markets are very overvalued and they will react accordingly by selling stocks. We have no way of predicting the depth of that selling.
Further, we believe that the great excesses of this credit cycle will lead to significant further pain. While credit spreads may now appear “normal,” they are well below previous peaks. We have earlier commented about reckless lending standards. Please see previous Curmudgeon Commentaries at:
The possibility of a credit downturn worse than anything seen in the last two recessions and bear markets (1990-91 and 2001-02) is significant, although by no means assured. At the peak of those downturns, credit spreads (junk bonds vs. Treasuries) widened to 12 full percentage points!
So avoid the tendency to buy the dips in stocks and junk bonds. Be very conservative in your asset allocation and maintain a high cash position. We think that the selling in municipal bonds – many of which have nothing at all to do with mortgages or buyouts- is way overdone and that municipal bond funds represent good value at current prices. We also like Gold, but not necessarily Gold shares which are subject to huge swings by hedge funds and other speculators that will reduce their correlation with the underlying metal.
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartrered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.