Might the Fed Cut Rates Again? Lehman Brothers' Demise Probably Means Yes

A rate cut may be in your future. After rising inflation worries put the markets on the alert for a rate hike earlier this year, the thought that the Fed's next move might be to cut rates would seem a little far fetched. At one time, using Fed Funds trading as a guide, nearly 75% of money was being bet on the side of a rate hike by year end. That very high bet on rate hikes has diminished in recent months, but the great majority of investors still believe that the next rate action will be up. I have a hunch; however, that a rate CUT is now nearly a 50% possibility and my reasons are simple: With the stock market down nearly 15% from a year ago, investors have lost nearly $2 trillion. In addition, with real estate prices down about the same amount, homeowners have taken another $2 trillion in paper losses. Without adding to the list, investors have taken a $4 trillion hit. That is a deflationary force that has not taken hold yet because it takes most people a long time to quantify these kinds of losses. But almost every asset they thought they had a year ago is now worth far less. My belief is that as the magnitude of these losses gradually reaches more and more Americans' psyches, they will begin to pull back even farther on their impulse and status purchases. I am not alone in my view that deflation is the biggest worry in the next few years. Thirty-year Treasury bonds yield only about 4.4%, far lower than the near 5% they yielded a year ago. The long bond crowd used to be called the bond vigilantes because they voted their inflation views with their Quotrons. If they thought inflation was a real problem that was not being addressed directly enough by the Fed, they sold long bonds, driving bond yields higher. If they thought the Fed was being too aggressive, they would drive yields lower, signaling the Fed was too tight. Thirty-year yields have been falling in recent weeks. The worries about the banks and the investment banks have created some flight to safety, but another bond yield shows clearly that the bond vigilantes are beginning to feel like the Fed needs to cut rates: 90 day T-Bills. Ninety-day T-Bills are currently yielding 1.45%. With Fed Funds at 2%, the bond crowd is signaling they don't want to put big money in the banks. They would rather take a lower yield from the government than the higher Fed Funds rate from the banks. The average difference between Fed Funds and T-Bills over the last 30 years has been .25%. With the difference now .55%, and long bond yields falling, the bond vigilantes are saying deflation from a slowing economy is a bigger worry than inflation. I realize this may fly in the face of conventional thinking and current inflation stats, but I have always considered the bond vigilantes the smartest trading crowd on the street. You can be sure Mr. Bernanke is watching. To get through this rough patch with the banks, we must have a strong economy. The economy is losing too many jobs, thus soon at a bank near you, you might find a lower rate. Addendum: The Lehman Brothers situation. Unless there is a miracle of some sort, Lehman Brothers, the 158 year old Wall Street firm, will soon close its doors. A last minute attempt by Treasury Secretary Paulson to convince, badger, cajole, plead, and all the other verbs that cry out for somebody to do something, appears to have failed. Clients of Lehman should be OK. SEC rules requires that client positions be transferred to the next owner of the firm. That said, however, billions of dollars of capital will vaporize in the fear-induced selling that has gripped the shares of big Wall Street investment banks. As we have learned bit by painful bit, they are all up to their necks in bad loans and increasingly investors have given up on them; as has the US government, since it refused to bail out Lehman. Without the government's largess, no large bank, sovereign wealth fund, private equity firm, or investment bank was willing to take a chance on what was thought to be the smartest bond firm on the street. The markets will probably be rocky on Monday. Uncertainties will certainly abound, but the failure of institutions with failed strategies was inevitable, and the markets will be better for it in the long run. Just as inevitable was the fact that the US government would stop bailing out companies who appeared to have no moral, ethical, or financial compass by which to steer a new more profitable course. These companies bet the ranch on high risk debt: but they were dead wrong, and the ranch will soon have new owners. I look for most of the other pure investment banks to seek new owners in the days ahead. Even venerable Goldman Sachs seems to have lost some of its hubris. We are going to make it through this travail. There will be survivors and the survivors will have far less competition for business in a wide range of financial product offerings. Bank of America, Wells Fargo, and Barclays Bank appear to be the big winners so far. We'll keep you posted as the great disappearing of Wall Street firms continues.