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December 2, 2007

Tim Duy: Collision Coming

Tim Duy with more on how the Fed is likely to react to current economic conditions:

Collision Coming, by Tim Duy: Someone is going to get hurt bad, as financial market participants and Fed policymakers are barreling toward each other. Who will be the first to swerve? Whether the Greenspan put is real or not, markets are convinced that the Fed will flinch in the face of the ongoing panic. Is panic too strong? I think not, at least given the tenor of the financial press. From Bloomberg:

'People are losing faith in credit, so the economy is seizing up,' said Biggs, 74, who runs the Traxis Partners LLC hedge fund in New York and was formerly a strategist at Morgan Stanley.

Looking out the window, I sense “the economy is seizing up” is something of an exaggeration. There appears to be considerable activity at the local shops, my internet connection is solid, the electricity is on, etc. Some students appear unsteady on their feet, but I suspect this has more to do with post-summer finals revelry than impending economic collapse.

All joking aside, there is a real concern, and I can not say that I do not share it, that the situation is quickly getting away from the Fed. In my opinion, we are at a point where people no longer have the time to rationally analyze the incoming news, reacting to speculation and rumor rather than fact. Sounds like a good definition of “panic” to me.

The daily activities of the New York Fed, which have gone unnoticed for years, suddenly becomes an object of intense speculation about the intentions of the Fed. It is as if we have reverted to the days when the Fed did not announce policy decisions. Indeed, speculation is rising that the Fed has secretly cut rates already. Likewise, data analysis has become subject to exaggeration as well. I particularly enjoyed David Gaffen’s remarks from the Wall Street Journal’s MarketBeat:

That fear is normal, however, and the indiscriminate selling that characterized the mid-afternoon represented the fullest representation of all-out panic. After all, the catalyst was the Philadelphia Fed’s manufacturing survey, which probably ranks somewhere around 12th in terms of significant economic releases (at best).

Somewhere around 20th in my book. In contrast, the positive read on manufacturing from the New York Fed was essentially ignored. And the Wall Street Journal’s Joanna Ossinger writes:

Meanwhile, the Labor Department said jobless claims were up in the week ended Aug. 11, which could signify even broader troubles for the consumer.

Again something of an exaggeration given that initial claims have been trending in a 300k to 350k range for months and this week’s number is essentially unchanged from a year ago.

Of course, all of this data analysis is essentially spitting in the wind; last month’s data appears like ancient history as the subprime bubble unwinds. Therein lies a problem – I doubt the Fed finds it to be ancient history. They tend to want to see hard data before they change policy, and as I argued yesterday, the data flow does not appear conducive to a near term rate cut.

Moreover, I thinking they will be sifting through the financial carnage to determine if the “credit crunch” is primarily centered on firms with direct ties to the housing market, or more specifically, to the riskier parts of the housing market. They will want to know to what extent the good is being swept up with the bad; what is simply a jarring reassessment of risk. For example, evidence such as the stability of the conforming loan market (via Brad DeLong) would allow them to maintain their story that the fundamental problems are largely contained. And despite numerous stories of a credit crunch in the commercial paper market, I can only find examples of real estate related firms that are having funding difficulties (mortgage companies, REITs, etc., using mortgage backed assets as collateral). Pease alert me to others. I doubt that a rise in commercial paper rates alone as this described by Bloomberg

Lenders are so concerned about the fallout from rising delinquencies on subprime mortgages that rates on commercial paper have shot up to 5.90 percent from 5.36 percent a month ago, data compiled by the Federal Reserve show.

would send FOMC members into a frenzy.

I fully and completely believe that the Fed does not want to cut rates in an intermeeting move; I suspect they don’t want to in September either. I very much doubt that policymakers are sympathetic to the plight of hedge funds, mortgage companies, investment banks, etc., who are getting caught trying to unwind a stack of securities that they euphorically created but apparently did not fully understand. These are the ones crying the loudest for a rate cut, despite ignoring for months the warnings of Fed officials regarding excessive risk taking. (Of course, the Fed should be sharing the blame; policymakers chose to abrogate their regulatory authority years ago. But don’t look for a mea culpa. I learned long ago that the Fed does not make mistakes.)

That said, the Fed could very well be driven into an interrneeting rate cut at this point. Again from Bloomberg:

'What the market needs is some kind of assurance that the Fed is on their wavelength,' said Jim Glassman, senior economist at JPMorgan Chase & Co. in New York, who used to work at the Fed. 'The more entrenched the psychology of fear becomes, the more the Fed is going to have to do to snap it.'

At this point, would a 25bp. rate cut actually improve confidence, or will the opposite be the case? The Fed’s liquidity injections, which I believe have been widely misunderstood, appear to have only heightened the sense that the Fed knows something secret about a bank or hedge fund facing imminent collapse. And St. Louis Fed President William Poole said Wednesday that only a “calamity” would justify an intermeeting cut. So if they do cut, by definition we are in a calamity. I must admit that does not inspire confidence.

Moreover, does anyone really people that 25bp will save those being cut in half by the subprime mess? Fundamentally, the problem is that both homeowners and one segment of the financial market bet the housing prices would rise in perpetuity. Now that the delusion is shattered, and investors have to admit the world is actually a risky place, will subprime, or even Alt-A, ever be the same? Indeed, the path of the housing market was already set long before the last two weeks. The Fed admitted as much in the most recent policy report to Congress. 25bp will not rekindle the subprime fire that heated the housing market to the boiling point. Neither will 50bp, or even 75bp. My experience is that you cannot reflate a bubble, you just make a new bubble – tech stocks to housing to private equity to…?

That said, I am not as bearish as I sound; consumer weakness via a housing slowdown was already built into my forecast. I believe more things are right than wrong with the economy, and I am sympathetic to this also from the previous Bloomberg piece:

'An immediate rate cut would be a significant overreaction and possibly sow the seeds of an inflation problem,' said Michael Darda, chief economist at MKM Partners LP in Greenwich, Connecticut. 'The Fed is in a difficult position, but has to keep its eye on the price-stability ball.'

So there you have it; collision ahead. Either the short end of the yield curve is ridiculously overbought and a lot of people are going to get caught in a short squeeze, or the Fed will be eating some serious crow before the September meeting. My inclination remains to bet against an intermeeting cut as I am confident that the Fed has little interest in pulling that trigger. Given the turmoil, however, it is difficult to completely rule out such a move.

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