Wednesday, October 31, 2007

Well, short help is better than no help at all

Well the 204 readers who voted for a 25bps cut got it right. Prior to today's announcement, the market was widely expecting another cut in December. We'll see how the futures start trading after the release has been fully digested.

The real question is where do we go from here? I think the odds of several more cuts have risen substantially. Today's GDP report, and Hoenig's dissent not withstanding, the Fed is rightfully concerned about the strength of banks, and if weakness continues in that sector I'd expect the Fed to keep cutting. In essence this would allow banks to earn their way through any troubles through carry.

Commenters will cry out Moral Hazard! Moral Hazard! But having read Bernanke's academic work on the Great Depression, you can't help but think he'll err on the side of providing too much liquidity if the alternative is risking the banking system.

How many cuts we get exactly depends on the extent of the housing problem as well as how quickly it deteriorates. If home price appreciation was mildly negative for a year or two nationwide, then about flat for several years thereafter, that would be manageable without deep cuts in rates. If we see -10% each of the next two years, I think the Fed gets more aggressive.

What will be the consequences of more cuts? Well, a steeper curve to begin with. I'm bearish on the long bond, and would be cautious on loading up in the 10-year area. I'm focused on 3-7 year bonds.

The dollar will probably continue to struggle. If that can continue to prop up exports, that might help the housing problem by keeping people employed.

I think you will also see a rotation in both credit and stocks, back into financials and away from consumer cyclicals. The market will wake up the reality that consumer cyclical firms are the ones really vulnerable to an extended period of housing-driven weaker consumer spending.

5 comments:

Dave M. said...

AI said..""In essence this would allow banks to earn their way through any troubles through carry. I think you will also see a rotation in both credit and stocks, back into financials and away from consumer cyclicals. ""

I agree. I'm loading up on stocks of regional banks and BTO is a closed end fund of regional banks trading at a 12% discount to NAV. Chart looks like a double bottom and a good buy here. 10% managed distribution plan with almost all divys classified as long term cap gains.

Darth Toll said...

I won't give you the moral hazard speech because it's way too late in the game for those arguments. The Fed can't move much from here. They appear to be caught between a credit crises on one end, and a crack-up commodity boom on the other. Further dollar weakening cannot be tolerated. It's not that they care about inflation that much - heck they are one of the main sources of inflation! The problem is the GDP chain deflator and the crack-spread.

Consumer prices have reached the puke-point where any more push inflation gets met with decreased demand. That is why the GDP deflator came in at the lowest point in the last 53 years. Margins are getting squeezed big-time. Look at what TSO and XOM just said and VLO and others have already said. They cannot tolerate $95/bl oil when the consumers will cut back when gas is over $3.35/gal. The crack spread is dangerously close to inverting. All manufacturers of consumer goods will be met with more puke-point problems as the dollar weakens, not just the cyclicals, and their margins will erode. Short of a full-fledged helicopter cash drop, Joe Six Pack can't tolerate more price increases as his wages remain stagnant, his house is going down in price, food, energy, and everything else is skyrocketing with these inflated dollars.

Also, its way too early to make a case for buying the financials (look at the DSL bloodbath and other regionals as an example). The reason is that the banks are also carrying a lot of bad debt which needs to be written-down/written-off, and many banks won't make it at all. We won't know how deep the rabbit hole is until all of the mark-to-make believe nonsense has been resolved.

Obviously I'm in the -10% a year for the next two years camp. CR supports this saying that the next two years will be the worst for house price depreciation if this cycle follows previous cycles.

K-Winter isn't coming anymore, it has arrived.

Tee said...

I think there will be more cuts coming, as FED seems to respond to the situation (i.e. subprime, credit crunch etc.) rather than the price environment. Impacts from subprime will continue in various forms, which will create pressure on FED to cut rate again. Benign core CPI will support FED decision to cut rate, but the benign core CPI is reflecting the weak condition in the US. Rate cut, as I understand, will support consumption/investment, which will result in higher US trade deficit. FED's rate cut will also result in a higher inflationary pressure in US's trade partners. I therefore expect most countries (excluding US) to make decision on rate hikes (not rate cut). I think the further FED's rate cut will complicate FED's monetary policy in the future, once the US economy starts to absorb inflationary pressure from trade partners.

Accrued Interest said...

I think the case for financial stocks is difficult. I mean, I don't actually follow individual stock valuations closely, but even a stock like CFC isn't trading like its likely to go out of business. Therefore you can't merely make the "they'll survive" argument for owning the stock.

Take Amazon's stock. In 2000, the stock was down 80%. You could have argued that "they'll survive" and you would have been right. But the stock was down another 30% in 2001. Now of course, in 2002 and 2003 you would have made a killing, but my point is "survival" and "good stock buy" are two different things.

That isn't to say that any of the banks are good or bad stocks, but you really need to feel comfortable that the bank is on top of their loan losses. Although I disagree with some of what Darth Toll said, its fair to say that there is little clairity on loan losses at most big banks.

Bond guys can play the survivor game, but stock guys can't.

Anonymous said...

And thus it begins...

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And more truth about the Citi bailout - excuse me, the MLEC:

http://tinyurl.com/37wgfw