Why the Rate Cuts Won't Work
September 20, 2007Ben Bernanke has taken a close look at the economy and doesn’t like what he sees. That is the only explanation for the 50 basis-point cut in both the discount rate and fed funds rate. Previously the Chairman made it clear that, in a change of policy from the Greenspan regime, the FOMC was using the discount rate to provide funds to the seized-up credit markets, intending to use a fed funds rate cut only if the financial market turmoil was spreading to the real economy. The fact that they not only cut the rate, but did so by 50 points indicates that the Fed takes the possibility of recession very seriously, as indeed they should. As we’ve written previously, most of the indicators we look at indicate the probability of a hard landing or recession and the Fed is privy to the same facts and much more, although, as usual, they have been slow to pick up the hints. August housing starts fell 2.6% to the lowest level since June 1995. Single family starts were even worse, declining 7.1% to the lowest level since April 1992. The National Association of Homebuilders (NAHB) Index dropped to 20 equaling the record low reading of January 1991. Nationally, 3.56% of mortgages were at least 30 days past due in August, a jump of 1.5 points since late 2005. Half of the increase has occurred in the last three months alone, and delinquencies were up in all 50 states. The sharp rise is a forerunner to increased foreclosures, which are likely to be widespread. Yale economist Robert Shiller stated that "The collapse of home prices might turn out to be the most severe since the great depression." Alan Greenspan said that a double-digit decline in home prices would not be surprising, a sentiment echoed by an increasingly wide array of economists. Such a decline, the most in 70 years, would most likely have an economic impact far greater than the meltdown in the subprime mortgage market. The meltdown in housing values will also far exceed the previous meltdown in the dot-coms earlier in the decade and with much greater impact. The Center for Responsible Lending predicts that foreclosures on subprime loans will lead to cumulative losses of $164 billion in home equity, while investment banks have estimated that the costs to financial institutions could amount to over $300 billion. Various experts testifying at a congressional hearing estimated that a 15% decline in house prices could wipe out $3 trillion of household net worth. US residential real estate has an estimated total value of about $21 trillion, the largest component of the wealth of most households. The housing malaise is spreading to the rest of the economy. The growth rate in employment has been declining for more than a year and the number of jobs actually fell in August even with the substantial addition of fictitious jobs from the birth/death adjustment. Non-auto retail sales were down in August. The National Retail Federation predicted a rise in total holiday sales of only 4% for November and December, the slowest since 2002, blaming slow job growth, chaotic credit conditions and falling house prices. FedEx, a key economic barometer, slashed their earnings forecast as a result of financial market volatility, high energy costs and weakness in housing. Credit Suisse analysts’ transportation industry channel checks showed that the economy "is in the midst of a domestic freight recession." Corporations, too, are not immune to the weakening economy. Standard & Poor’s predicted that a new wave of business failures would hit corporations. The firm said that 75 junk-rated companies are at high risk of defaulting over the next 15 months as a credit squeeze impacts weak, highly-leveraged companies. Semiconductor equipment book-to-bill ratios dropped to 0.80 in August, the lowest level in two years. Bookings are down 19.4% from a year earlier. Moody’s Economy.com said that their index showed the probability of recession jumping to 40% in August, the highest since 2001. Given the dire economic outlook, we believe the fed rate cut will not stop the economy from a hard landing or recession and that stocks will decline sharply as they did after the first rate cut on Janauary 3, 2001. On that day the S&P 500 jumped 5% and Nasdaq an astounding 14% (no typo). Over the next 21 months the S&P plunged 43% while Nasdaq did far worse. The fact is that central bank rate cuts are not much help during the bursting of a major asset bubble. This was the case in the US following 1929, Japan following 1989 and the US from 2000 to 2002. In each case inflation was low during the bubble, thereby allowing central banks to let asset values soar with little response. The total value of US houses is far greater than the value of technology stocks in 2000, and ownership is much more widespread. The impact of bursting housing values is therefore likely to be far more serious and widespread both for the economy and the market. Furthermore, in the short time since the rate cut the 10-year Treasury bond yield has jumped 17 basis points, the TIPS spread has widened, the dollar has dropped and gold has soared. It seems that for the first time in many years the bond vigilantes are back in business and threaten to undo some of the short-term rate cuts. As we have been saying for some time, the Fed has progressively been painting itself into a corner and now has very little room to maneuver. It is faced with potential debt deflation on the one hand and inflating its way out on the other. For now the Fed has chosen to try to avoid the debt deflation, but in an indication of their ambivalence, avoided including a risk assessment statement in their release following the meeting. In our view the Fed is in a box that even Houdini would have trouble escaping. Although former Fed Chairman Greenspan bears a great deal of responsibility for the current mess, in a moment of clarity at last year’s Jackson Hole conference he stated "Thus this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy, but what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of debt that supported higher asset prices. THIS IS THE REASON THAT HISTORY HAS NOT DEALT KINDLY WITH THE AFTERMATH OF PROTRACTED PERIODS OF LOW RISK PREMIUMS." (Caps are ours). http://www.comstockfunds.com/index.cfm/MenuItemID/29.htm |
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