Wednesday, December 17, 2008

Fed Cuts The Funds Rate To Just About Zero

No Bazooka Here, More Like An Atomic Bomb

Bucking the expectation of a 50bp cut in the funds rate to .50%, the Fed took out the big guns and instead set up a target range of between 0% and .25%. In doing this they acknowledge that the economic environment is even weaker than many thought, and that they are committed to doing whatever it takes to get us out of one of the worst recessions ever. Whether this rate cut will have any impact is debatable, but some of the other weapons they will use might.

The Fed, led by Chairman Bernanke, pledges to use extraordinary measures to deal with the longest recession in a quarter century. Some of these include buying large quantities of mortgage debt in an attempt to lower rates and boost liquidity. The central bank was still "considering" buying long-term Treasury securities, which is also thought to be aimed at lowering borrowing costs by going around commercial banks. All of the steps that the government has taken to date has increased the size of it's balance sheet from $900 billion to $2 trillion.

What Is The Fed Trying To Say?

In a nutshell, this type of bold action by a Fed that is typically measured in its approach to problems indicates that things are in worse shape than they thought, and that throwing the kitchen sink at the problem is the only way to handle things.

In a perverted response the stock market took off to the upside, possible viewing this move as the true beginning of the end of the recession. The stock market will typically start to move up six months prior to the official end of a recession in anticipation of the improvements to come. On the other hand, it is possible that in an environment of tired sellers and thin markets the path of least resistance, at least today, is up.

Bank stocks, led by Goldman Sachs post earnings had a big day, and GE said the dividend is good for now and that they will not be giving earnings guidance going forward. When markets react to bad earnings or any bad news by rallying, it is an indication that the worst has already been built into prices. Unless it hasn't been.

Investing In Bond

The 30 year Treasury rallied huge today pushing the yield down to 2.82%. The 2 year is at .67%. Given the amount of borrowing that the government is going to have to do to finance all of the things that it has committed to finance, and the prospect for a spike in inflation once we begin to pull out of this recession, the 30 year is probably not the place to be unless you will need tax losses if you have to sell it down the road. The place in fixed income to be at this point in time would probably be in high quality corporates (if you can identify which company's are still high quality) that are being priced at spreads to Treasury bonds that are much wider than historical norms (non-Treasury fixed income is typically quote at some spread of basis points over Treasury debt. For example a corporate bond might typically trade +275 basis points to a comparable Treasury maturity).

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