Fed Aggressively Cuts Rates

The Fed lowered interest rates today but farther than many (included myself) had expected. Recall, I had anticipated the combination of a 25 basis point fed funds rate cut and a 50 basis point discount rate cut. Along with this, I expected a statement that indicated further rate cuts would be forthcoming as needed.

Recall there are currently two problems facing us -- a slowing economy, which the fed funds rate impacts, and a liquidity/credit crunch crisis that the discount rate addresses. And, there is the question of how much the US economy will slow in upcoming months. Nobody knows this for sure (no matter what they pretend). And, the two "dangerous ingredients," the slowing economy and credit crisis might possibly combine and become very "explosive," meaning cause a more severe slowdown and/or recession. Apparently, it is this potentially explosive combination that the Fed reacted to. And, given the lags in monetary policy changes (6-9 months), the Fed HAD TO BE PROACTIVE. Remember, Ben Bernanke has not been the Fed Chair for very long, so he still has to establish his "Fed Cred," or credibility. And, all the press play for former Chair Greenspan's book probably influenced the magnitude of the move somewhat (this Fed can't allow itself to possibly be "behind the curve" of this slowdown.

The result TODAY: the stock market got what it hoped for, so there was a major increase, +335 points for the Dow Jones, a full +70 points for the NASDAQ, and +43 points for the S&P 500. Shorter duration interest rates fell, a very healthy sign (we will discuss this in the next week it has to do with the yield curve) for future growth prospects. And, the exchange rate picture was mixed: the US dollar rose against the Japanese Yen, but fell against both the Euro and British Pound.

The chart shows Cyclicals ($CYC) for the past three months (click to enlarge). Note how, over this period, the 50-day moving average was originally support (until late July), then became resistance. Today, after the Fed's rate change, there was a very large increase. Note how tall today's bar is and that the close was at the day's high. More importantly, today's close broke above the 50-day moving average. Also, look at the RSI(9) above the cyclicals. It has recently moved into the bullish range, above 50. Finally, the price relative, comparing cyclicals to the stock market (in terms of the S&P 500) has turned up recently. Part of today's large increase was the result of "short covering," where persons had sold shares of various stocks betting that their prices would decline. When the news came out, they hurried to buy back the stocks (covering their shorts). This added demand was an important contributor to today's large run up in prices.

What about tomorrow? Now that the markets got what they wanted, there will no doubt be further deliberation and possibly second guessing of the Fed's decision. Was the large rate cut a sign that the Fed thinks things are actually worse then they have led us to believe up until now? Will today's breakout be sustained, or will something else come to the forefront, making today a "one day wonder," or in technical terms, a failed breakout. Keep following cyclicals through the rest of this week into next week.

August Employment Report

The August employment report came in with a bang. While the consensus prediction for payroll employment was around +110,000 (I had figured around +50,000), the figure released by the Bureau of Labor Statistics was -4,000 -- the first month-to-month decline in four years. Ouch!! You can read about the report.

As I stated in class, this would clearly be one of those "other things are not equal" situations. On the one hand, a weak employment report further fuels the expectation that the Fed will lower rates at its next meeting on 9/18, possibly by 50 basis points (1/2 of a percentage point). That is a positive for the stock market (which is driven primarily by profit expectations and interest rates).
But, weak employment signals less spendable income in future months, which will cut into profits, a negative for stocks. Which effect would dominate? As the morning unfolded it became readily apparent that the negative aspects were more than offsetting the positive factors.

But how could this be? If the Fed will be lowering interest rates soon, and the unemployment remained unchanged, why so negative a reaction by the markets? That's where it is necessary to read the details of the report. First, let me state a rule for judging reports: NEVER PLACE TOO MUCH WEIGHT ON A SINGLE MONTH'S VALUE. Actually the markets didn't. As it turned out, the employment totals for the prior two months were revised sharply lower. This brings me to a second rule: ALWAYS LOOK AT REVISIONS TO PRIOR TIME PERIODS BEFORE JUDGING THE CURRENT VALUE. So, instead of having an average monthly employment gain of around 110,000 over the past three months, the average (with revisions) becomes only +44,000. In addition to this, a further examination of the unemployment rate is called for. While the unemployment rate remained unchanged at 4.6%, the labor force dropped sharply. Had the labor force participation rate (% of population in the labor force) remained the same as it was last month, August's unemployment would have surged to 5%. Now it should become more apparent why the negative reaction occurred.

It is important to keep in mind that the primary factor determining whether a recession is upcoming is whether housing weakness is "contained." The dominant view has been that as long as employment remains strong and the unemployment rate doesn't rise too much, persons should generally be able to afford their mortgages, limiting housing damage. Well, in August, employment fell and the unemployment rate should have risen (with the same participation rate as last month). So, it is not clear how much "containment" will exist going forward, raising the likelihood of a recession (my estimate this entire year has been 45%, well above the consensus until very recently). Add to this the fact that a very large number of mortgages will be "resetting" to higher interest rates in October, and you can see the basis for the stock market selloff. Here's an article highlighting whether a recession is likely.

While we haven't covered it yet, another big reaction to the weak employment report was a sharp drop in interest rates. The 10-year government bond, which is linked to mortgage rates, fell from 4.50% to 4.37%, a 13 basis point drop in one day!! Bonds are fixed (nominal) income assets, meaning they pay fixed amounts of income per year. "Bad news" about the economy, like this employment report, is good news to the bond market as it implies less of an inflation threat in the future (inflation lowers nominal income). And, we will see (later this coming week) that bond prices and interest rates move in opposite directions. So, on Friday we had a stock market sell off and a bond market rally!! Finally, not unrelated to all of this was a sharp rise in gold prices. See if you can figure out gold prices rose. (Hint: it is related to interest rate changes.)

All of this should demonstrate the point I made the first day of class: if you understand macroeconomics you tend to think in terms of sequences (sets) of variable changes, not just what is happening to a single variable. The ability to do this takes practice. Judging by the way this semester has started, you'll be getting lots of practice!