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We Can’t Handle Interest Higher Rates

MacroMaven Stephanie Pomboy reflecting on interest rates a few years backed quipped that the US economy could no longer handle higher interest rates in a way that mirrors what Jack Nicholson shouted to Tom Cruise in A Few Good Men that he couldn’t handle the truth. Jack Nicholerson (Col. Jessup): You want answers? Tom Cruise (Kaffee): I think I'm entitled. Jack Nicholson (Col. Jessup): You want answers? Tom Cruise (Kaffee): I want the truth! Jack Nicholerson (Col. Jessup): You can't handle the truth! “Son, we live in a world that has walls and those walls need to be guarded by men with guns.

Who’s gonna do it? You?… I have neither the time nor inclination to explain myself to a man who rises and sleeps under the blanket of the very freedom I provide and then questions the manner in which I provide it. I would rather you just said “thank you,” and went on your way. Otherwise, I suggest that you pick up a weapon and stand at post.” Colonel Jessup’s responsibility to provide for our essential freedoms is not unlike the Federal Reserve’s mandate to create jobs and foster economic growth. And right now, that apparently requires the Fed to cut rates aggressively to guard the walls of economic growth from crumbling down.

To curb or otherwise fight the rising walls of inflationary pressures in our economy, the Fed had steadily raised short term rates to 5.25% by mid 2006. However, the 50 bps cut on Sept 17 was a loud and clear message from the Fed to the financial markets on Sept 17 with their 50 basis point rate cut is that we can’t handle higher rates. So, let the wall of inflationary pressure rage on for the time being. The Bernanke Fed’s 50 bps rate cut implies that the Fed’s team of Macroeconomic and Quantitative analysts (MAQS) analysts who have been busily studying a series of what-if scenarios for the US economy over the past few weeks must not have liked what they saw. The MAQS team under the Bernanke Fed was created to ensure they do not embark on a series of excessive rate cuts during instances of stress on the financial system. The Bernanke Fed feels in hindsight that Greenspan’s third rate cuts in 1998 as well as the aggressive easing in 2001-2003 were a bit excessive and that “the Fed [actually] overpaid for risks that the turned out to be less severe.” San Francisco President Janet Yellen noted that a good example of the Fed overypaying in the past followed the “aftermath of the Russian debt default in 1998. Many forecasters predicted a sharp economic slowdown as a result but growth turned out to be robust.” The third cut in November 1998 occurred when GDP growth in Q4 1998 came in at 6.

The what-if scenarios that the Fed’s team of analysts have been working on, a. “Alt Sims” or alternative simulations, adjust “for such things as higher financing rates… a sharp decline in home prices” or a sharp acceleration in mortgage foreclosures to catch a glimpse of possible future outcomes by leaving rates unchanged or relatively unchanged. The scenarios under a “relatively unchanged interest rate environment” must have been downright ugly. In seeking just the right amount of rate cuts that will be required for this credit crisis, the Fed certainly felt 25 bps would certainly be far too little. This too underscores the Fed’s grave concern for the US economy in a way which also mirrors the Fed’s sudden and grave concern for the US economy that emerged in January 2001. On January 3rd 2001, the Fed surprised the financial markets with an interbank meeting 50 bps rate cut. They followed that with another 50 bps rate cut on Jan 31 2001, then 50 more bps on March 20 2001, May 15 2001, and Sept 17 2001.

They cut 200 bps inside five months and 250 bps inside the first nine months of 2001. That forever damned the US dollar. It took awhile for the dollar to succumb to the Fed’s aggressive rate cutting, but in the end, it finally caved in by triple topping between Oct 2000 and Jan 2002. Peak valuations for the dollar at that time ranged from 119-122. Six years later, and the dollar is now worth only one-third of what it was when we began this decade. Whether the Fed Funds rate plunges 200 bps or more over the next three quarters is unknowable. The sooner they begin cutting only 25 bps at each FOMC meeting the better. There is a almost unshakeable faith in the Fed’s ability to navigate their way through financial turmoils with a policies of monetary accommodation. And equity markets tend to do extremely well during these Fed cycles of monetary accommodation. That is why they say on Wall Street “Don’t Fight the Fed.

” The only time in recent history that equity markets did not fare well during a Fed cycle of accommodation was in 2001. In that year, the SP 500 fell 22% from the second 50 bps rate cut on Jan 31 2001 by March 22 2001. While I do not expect a similar outcome for equities, as the economic backdrops are entirely different, we must still be cognizant that the Fed is not infallible. There is always the possibility that they have fallen behind the curve in responding to the current financial crisis, but as yet there is no such indication that is the case. John Bougearel Event-Driven Investment Research www.financialfuturesandequitymarketanalysis.com/.


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