Fed cut the discount rate today by 50 basis points

Let?s get the technical points out of the way first and then get to the analysis. The Fed cut the discount rate today by 50 basis points to 5-3/4%. The funds rate, however, was left unchanged at 5-1/4%. There is a big difference between the two ? the discount window is where the banks can borrow from the Fed; the funds rate is the rate at which the banks borrow from each other in the inter-bank market. Very little borrowing is actually done at the discount window ? in fact, in the week ending August 15th, on average there was $271 million of such borrowing conducted versus $258 million for all of July. The discount rate is still 50 basis points above the overnight rate; and while the Fed extended the borrowing period to 30 days, the discount rate is still at a 25 basis point ?penalty? relative to 1-month Libor. Clearly the Fed is trying to entice institutions that cannot access funds in the marketplace to borrow from the discount window ? maybe in order to gain information as to who is really in trouble from a funding standpoint.

Fed is walking a fine line

Needless to say, we have never seen the Fed cut the discount rate this much without a change in the funds rate, so clearly it is trying to send a message to the markets without having to imply that it is panicking. Talk about walking a fine line. Cutting the funds rate would have been a really big deal since it would be an admission that the Fed is now extremely nervous about the economic outlook; and for the markets this would have suggested a bolder move ? that the Fed is now willing to supply liquidity on a more permanent basis. Note that in contrast to what some believe, the Fed has not lowered the credit standards on collateral they will accept, in other words the collateral base has NOT been expanded. However, as is always the case, the Fed by definition accepts a wider base of collateral at the discount window than it does in its repo operations.

Today?s discount rate cut is symbolic in nature

We think that today?s discount rate cut is mostly symbolic in nature (though companies such as Countrywide through the bank counterparts are allowed to borrow at the discount window). The real message is in the press statement today which is vastly different from what we saw last week at the post-meeting statement. Not a word about inflation this time ? the Fed said that it is ?monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets?. At the same time, the Fed clearly acknowledged that ?downside risks to growth have increased appreciably?. More on this later.

So this is step two in what will turn out to be a three-step process ? It?s called Baby-Step Bernanke:

Step 1 ? Large scale liquidity provision in the interbank market

Step 1 was the large-scale liquidity provision in the interbank market over the past week. The evidence in terms of market pricing suggests that this was not entirely successful in dampening volatility or weakness in the capital markets, except to say that without these repo operations, the situation could have gotten a lot worse.

Step 2 ? Discount rate cut

Step 2, it would seem, is largely a symbolic move today to cut the discount rate aimed again at calming market jitters. But it?s really unclear as to how cutting the discount rate by 50 basis points is going to achieve very much (except, say, give the Fed more information about who is in trouble). But this is all very likely a prelude to an eventual cut in the Fed funds rate, which we think the Fed should have actually done today. Be that as it may, we can understand why the Fed may want to save the real guns for later and see if Step 2 does a better job at quashing the market nerves than Step 1. Besides, the Fed may be ?saving face? in view of the hawkish tone in last week?s press statement press statement, not to mention what it would have done to Bill Poole?s reputation (though he is retiring next year). The Fed obviously believes that the discount rate cut combined with the new wording of the press statement is going to at the minimum eliminate concerns that the Fed was not on the same page as the investment community.

Fed has acknowledged that credit conditions have worsened

But the real key is the Fed?s acknowledgment that credit conditions have worsened and spread ? the word ?contained? is now forever stricken from the central bank?s lexicon. The FOMC now sees that ?downside risks to growth have increased? ? and not just ?increased? but have done so ?appreciably?. This is tough language, especially compared to what we saw just a week ago. And it does indeed leave one wondering why the Fed didn?t bite the bullet and get more aggressive today by cutting the funds rate outright if the Fed has altered its risk assessment over the economic outlook that much. Perhaps the Fed is hoping that in addition to the symbolic message from the discount rate cut, the pledge in the press statement that the FOMC ?is prepared to act as needed to mitigate the adverse effects? is a powerful enough verbal commitment, that the Fed stands ready to do what is necessary to stem the tide of negative investor sentiment and minimize the damage to overall economy.

Step 3 ? 50 basis point cut in the funds rate

So what is Step 3? It is a 50 basis point cut in the funds rate, and whether it is at the September 18th meeting or before that will hinge on how the markets react to today?s initiative. It pays to note that today?s action was geared towards signaling to the market that it is prepared to cut the funds rate, but the Fed also seemed to take aim at minimizing the market turbulence that would require an intermeeting cut. This Fed is clearly working in incremental ways and today?s move and statement is a clear step towards a cut in the Fed funds rate. If conditions do not stabilize, the Fed will not wait until the next meeting on September 18th and will cut 50 basis points based on the wording chosen in the press statement and the size of the discount rate cut. If conditions do manage to stabilize, the Fed will not sit back ? it knows that the futures market had already begun to price in the prospect of a 50 basis points by September 18th, the equity market now sees this as a strong possibility itself, so the Fed is highly likely to carry through with a 50 bp cut to the funds rate no matter what else happens between now and then. If the Fed does not go at all, or only goes 25 basis points given what the press statement acknowledged about the risks to the economic outlook, the risks of a major market backlash not unlike what we saw with a similar tepid move on September 29th, 1998 after the LTCM/Russia debacle ? the next day the stock market sank 3% in a major ?thumbs down? and there was another 5% downleg to the S&P 500 to come before the Fed realized it fell short with only a 25 beeper ? it was forced to go intermeeting on October 15th by 25 basis points. We believe the Fed should, and hopefully will, avoid that 1998 mis-step and go the full Monty at the next meeting, even if markets stabilize. The longevity of that stability is going to hinge critically on the Fed making a bold strike.

High prospects for a Fed rate cut by or at the next meeting

So we see the prospects as being very high that the Fed cuts rates by or at the next meeting, and by 50 basis points since a 25 basis point would risk a market backlash. There is too much time between that meeting on September 18th and the next confab at the end of October. The press statement that day (Sept 18th) will tell us whether the Fed believes that there will be more to do (we think there will be). But today?s statement showing their concern over the REAL economy has, in our view, definitely set the stage for a ?Step 3? 50 basis point cut.

Will a rate cut stabilize the markets on a sustained basis?

The next question is whether even a cut in the Fed funds rate is going to help stabilize the markets on a sustained basis or even prevent a recession from occurring. We are willing to keep an open mind but are skeptical. History counsels caution on this file. The prior two asset and credit bubbles that unwound from 1990-92 and again from 2001-03 show that the Fed cut interest rates 100 basis points after the financial turbulence became to difficult to bear, and the central bank believed both times time that it acted in time to prevent a recession or bear market. The transcripts of the July 1990 and January 2001 FOMC attests to such ? recession was not on the horizon. But recessions did follow the initial Fed rate cuts back then, and so did a cyclical bear market in equities. Not even the Fed could stand in the way of nature taking its course and expunging the bad credits out of the system.

Asset and credit bubbles don?t unwind in an orderly fashion

There has never been an asset and credit bubble that managed to unwind in an orderly fashion, and what the historical record shows is that the Fed spends the first half of the rate-cutting cycle running backwards on the treadmill. It?s not until the second half of the easing cycle that the clouds really begin to part. We recall all too well when the Fed pulled that surprise rate cut on January 3rd of 2001 when it cut BOTH the discount and the funds rate by 50 basis points (the Fed cut the discount rate 25 bps that day and 25 bps the following day), the Dow surged 300 points or 2.8% and the Nasdaq soared 14% that day. Three months later, both were hitting new lows. Recall that the Fed was cutting rates 300 basis points to 3.5% before 9-11 back in 2001, and the S&P 500 was down 20% from the highs and hitting new cycle lows. Keep that in the forefront of your mind as you ?trade? the knee-jerk reaction to what the Fed said and did today. Also remember that the 10-year note yield jumped 22 basis points the day the Fed eased on January 3rd, 2001, and that represented an enormous buying opportunity for anyone with a six-month view ? from the session?s close on January 3rd through to June 4th of 2001, the 10-year generated a positive 9% return and outperformed the S&P 500 by 2700 basis points. We?re not sure the magnitude will be the same this time around, but the story will probably be broadly similar.

The Fed will be pushing on a string ... again

In other words, the Fed will be pushing on a string ? again. So in our view, it will end up cutting rates hard this cycle as it did in the aftermath of the last two asset bubbles. Pushing on a string means that the beneficial impact of a lower cost of capital is overwhelmed by the reduction in its availability (supply) or desire to borrow (demand) as lenders move to improve loan quality and debtors simultaneously move to repair their balance sheets ? both the byproduct of deflating asset values. That means that as we saw in the last cycle, and the cycle of the early 1990s, when an asset and credit bubble unwinds, lower interest rates initially exert a muted impact. This is because the rate relief typically bumps up against a prolonged tightening in lending guidelines by financial institutions as default and delinquency rates continue to rise and the value of the collateral continues to decline. At the same time, the demand for credit dries up as we enter an extended period of balance sheet repair by the entities that participated the most in the asset boom ? households in 1991, corporations in 2001 and now back to households in 2007. The Fed staff economists published a report in August of 2006 titled ?A Trend and Variance Decomposition of the Rent-price Ratio in Housing Markets?. The results were startling ? only one third of the parabolic move in the home price-to-rent ratio this cycle was due to low interest rates. So those looking for lower interest rates alone to do anything but ease the pain as the debt excesses of the past cycle unwind are likely to be in for a big surprise.

Bond selloff is a wonderful buying opportunity

Remember ? in the early 1990s cycle, the funds rate fell to 3%. In the last cycle, cycle, it fell to 1% (and to 3.5% before 9-11); look for something in that range this time around as the Fed eases to soothe transition to a credit-contraction backdrop. Today?s bond selloff is a wonderful buying opportunity if this cycle plays out like its predecessors.