My prediction that the Federal Reserve would lower their target rate by 50 basis points was wrong, but in my judgment, they will see the error of their ways and continue to cut rates very soon. I do believe, however, that they missed the opportunity to stay out ahead of the unfolding worries in the subprime market.
Today's downgrade of Citigroup by Wall Street analysts is proof of the pudding, so to speak. Citigroup is down nearly 7% on rumors of more write offs and the possibility that they may have to cut their dividend. Citigroup's bad news has spilled over into the general market, pushing the Dow down nearly 1.5%.
If you recall in the
blog where I predicted the 50 basis point rate cut, my central theme was that the yield spread between Fed Funds and T-Bills was signalling continuing worries about the banks, especially the big investment banks. When the Fed Funds Target Rate is significantly above the rate on T-Bills, it is a clear message that sophisticated buyers are opting for government-backed paper over bank-backed paper.
When I first started talking about this phenomenon in early
September, the difference was over 1.25%, as high as it had been in nearly 20 years. As a result of the mid-September rate cut, yesterday that difference had fallen to near 1%. Yesterday, after the Fed announced only a 25 basis point cut and indirectly expressed the notion that future cuts may be unnecessary the yields on T-Bills began to fall. For those of you worrying about inflation, a fall in T-bill yields is a very big bet by very big investors that you are wrong. Indeed, a fall in T-bill yields says two things:
- The odds are increasing for a recession.
- The Fed got it wrong.
I do not believe there is a high probability of a recession, but I do believe that the Fed got it wrong. The good thing is, they can still get it right and well before the next meeting in December. Fed governors give speeches everyday. All they have to do is to take away the implication that the rates cuts are done.
They have now lost the lead in taming the ongoing banking worries, and they will have to do some heavy lifting to regain that position, but if they speak with one voice, they can regain their rightful leadership position by December.
As it now stands, the Fed Funds Target Rate is 4.5%. After yesterday's and today's rallies in T-Bills, they now yield about 3.7%, yield spread of about .8%. That is still high by historical standards and implies the credit and liquidity crunch is far from over.
The Fed is the banker of last resort, and I'm confident that they will ultimately get it right. Having said this, I think they made a mistake in reading the markets that Alan Greenspan would not have made.
