Tuesday, October 30, 2007
Trading in Fed Fund futures is signaling over a 90% probability that the Fed will cut rates on the 31st. Trading also suggests that the most probable cut is a quarter of one percent. That is also the best guess of our president, Mike Hull, who is now sporting a 0-1 win-loss record against me. Last time, I predicted that the Fed would cut rates by a half percent because I believed they recognized that a credit crisis was underway, and they needed to get out ahead of it and signal that they were more worried about an economic slowdown than an uptick in inflation. One of the indicators on which I based my prediction was the yield spread between Fed Funds, the overnight rates at which banks loan money to each other, and T-bills, the short-term rate at which the US government borrows money. That yield spread had spiked to more than 1.25%. I suggested then that such a wide yield spread was not only unusual (it had only occurred four times in the last 20 years) but a clear signal that loaning money to a bank was considered much more risky that loaning money to the government. This crisis of confidence regarding the creditworthiness of the banks jeopardized the economic health of the US economy and had -- and would continue to cause the banking system to freeze up, unless decisive action was taken. I advocated a 50 basis point cut as a preemptive move to "knock" the bankers on the head and remind them that the Fed was in charge not only of fighting inflation, but also ensuring liquidity in the banking system and economic growth. The Fed's subsequent 50 basis point cut was a bit of a surprise to the stock market and it responded by powering higher nearly 300 points. The Fed needs to cut rates by 50 basis points again because the yield spread between the Fed Funds rate today, 45 days after the last cut, is still nearly one percent: Fed Funds rate 4.75% and T-bills at 3.85%. In my mind this wide spread is still signaling the credit crisis is alive and well. I think the Fed should cut rates until the yield spread falls to no higher than .5%, and they need to do it swiftly. They currently have the liquidity crises corralled but not tamed. They need to tame it, and the best tool they have to do this is to continue cutting rates at a pace greater than the market predicts. The value of these continued sharp cuts will ultimately get the market's attention and allow equilibrium to return the banking system and the economy. If need be, the Fed can take back some of the rate cuts after normalcy has been restored. Even though I realize it is a long shot, put me down for a half percent cut. Shawn, Ken, David, Mike, Joe, Jay, et al, here's your chance to get your money back.