Wednesday, January 16, 2008

Astute observations on the Fed's recent actions to calm the credit markets

Courtesy of Cumberland Advisors -

Cumberland Advisors
614 Landis Avenue Vineland NJ 08360-8007

The Iron Stomach
January 16, 2008

Results from the Fed’s Term Auction Facility (TAF) are about as good as one can expect. Remember this is the Fed’s NEW tool and this is only the third time it has been used. The first two times were in December.

The Fed set a minimum bid of 3.88% and raised the auction amount from $20 billion in the last two auctions to $30 billion. The bids cleared at 3.95%. In December, the rates on the first two actions were 4.65% and 4.67%. Clearly rates are falling and the Fed is succeeding in bring them down.

That means US banks borrowed $30 billion in collateralized loans from the Fed using a mechanism that substitutes for the Discount Window. The official Discount Window rate is 4.75%. That will obviously change when the Fed meets at the end of this month.

The target Fed Funds Rate is currently 4.25%. Markets are pricing in a 50 basis point cut to 3.75%. The TAF auction implies that the Fed will deliver that 50 basis point cut on January 30th. So we project a Fed Funds Rate of 3 ¾% and a Discount Window Rate of 4 ¼% at month end.

We also project a successful TAF auction on Jan 28th. If there are any meaningful changes in the auction result, the Fed will know them in detail. We won’t but they will. That may change the outcome of the Fed meeting.

Inflation reports and employment data will not change this outcome. Neither will market volatility or earnings reports of companies. It will take a shock to cause the Fed to act between now and the month end meeting. Market agents who are forecasting some intermeeting rate cut are wrong.

Is the Fed policy working? The answer seems to be affirmative. The LIBOR rates are now below 4% in nearly all maturities. They are consistent with a TAF auction rate below 4% and with a Fed Funds target rate of 3.75%.

For the first time we are seeing the dysfunction in the credit markets being relieved by central bank actions. True: it would have been better if the Fed were ahead of the curve last summer and autumn. True: the Fed communicated poorly. True: the Fed has been playing catch up.

Also true that the Fed now sees it must restore credit markets to some normalcy. The Fed realizes that it cannot deal with policy questions of growth vs. inflation or moral hazard or mortgage lending operations or bank supervision----that’s right----the Fed cannot deal with the elements it has on its plate unless and until the credit market dysfunction is cleared. Hence, the Fed now “gets it.”

Meanwhile the stock markets are focused on earrings reports from the last quarter when the credit markets were in turmoil. The bond markets are finally starting to realize that the world is not coming to an end. The treasury market is driven by absolute fear both in the US and from abroad. Hence, we see falling treasury yields and a weaker currency at the same time. This is temporary.

We expect the bond markets to commence realignment. Cumberland has positioned in the spread sector of the markets we have sold nearly all of our treasury positions and added substantial yield as these spreads have widened.

As for stocks. My friend, Vince Farrell, recently quoted a colleague who said that the time to buy stocks is when the idea makes you sick. That is a good characterization. Right now the stock market is so ugly and frightening to investors that it is making them sick. One client wrote me and asked if I had an “iron stomach.” The answer is yes.

I have seen this professionally several times in my 38 years. The first time was in the bottoming process in the 1973-4 bear market when the Dow actually hit 600. That’s right, 600 not 6000. My then partner, Shep Goldberg, and I bought the market in November 1974. It was easy for us to do. Market pricing had lost all touches of value reference. Stocks were really cheap. Selling was indiscriminant. There were no buyers; they were on the sidelines. So prices just fell and fell and were hammered.

We suffered for three months. Clients fired us. Others yelled at us. That is when we got iron stomachs.

Three months later the bull market of 1975 was launched and history tells the rest.

The thought of buying stocks or owning stocks is currently making people sick. My internal client fear measure is about 10 to 1 against stocks. That is a classic bottoming indicator.

In answer to Vince Farrell’s friend, yes, my stomach is made of iron. I expect clients to look back on this period and be glad that they did not panic. And, yes, I expect that some will panic and then look back and regret it.

I put a little Tabasco sauce on the eggs and tested the iron this morning. It is still there. The CPI is out in a few minutes.

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