The US Federal Reserve cut its FED Funds Target rate by 50 bps from 5.25% to 4.75% indicating - "Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time".
In a related move it also cut the Discount rate by 50 bps to 5.25%.
Although the Fed Funds futures were indicating a 50.0% probability of a 50 bps cut, the broader market was expecting a 25 bps cut. So a 50 bps cut is definitely something to cheer about - and how!
The Dow gained 2.5% rising by 335 points. The 2 Year treasury yield crashed 15 bps to end at 3.98%. The dollar got knocked out to an all time low flirting with the 1.40 to the Euro mark. Financial stocks heaved a huge sigh of relief and posted strong gains across the board.
It is also great news for the 'export to US' dependent emerging economies - the Nikkei, Hangseng and the Kospi are up by 3.0% each. India would follow suit.
Concerns Remain - Inflation hawks have a different take on it -
With crude oil over $82/Brl, food inflation picking up, metals trending higher and a general higher inflation scenario around the globe - the 50 bps cut didn't enthuse the inflation hawks. They immediately reacted by sending the 30 yr Treasury bond yield up by 5 bps. Even the 10 year bond yield was up 5 bps after the decision. The US treasury yield curve is at its steepest. The spread of the 10 year yield over the 10 year inflation protected securities widened to 2.35%, an indicator of the expected inflation. Even Gold hit a 16 month high trading at $725 tracking the fall in dollar value and the overall concerns on inflations.
The euphoria should continue for a day or two and then what - Does it indicate the start of a long drawn easing of interest rates in the US?
The US economy has shown moderations in the first half of this year. Housing activity continued to worsen and employment slackened. Though retail sales showed a pick up last month, the general trend was one of a slowdown. Consumer confidence has been shaky. The after effects of the sub-prime mess threatened to derail the economic activity further. Credit conditions remain tight and mortgage lending activity has slowed down. The Housing industry is crucial to the US economy and the Fed sees a major risk to the economy on its deteriorating state.
One key reason for the rate cut would be to manage the amount of interest rate resets on mortgage loans happening in early 2008. Almost $520 bn of loans are due for repricing in the first half of 2008. A lower benchmark interest rate and a stable house price scenario then, would definitely aid in managing the re-pricing, without too much risk of higher delinquencies and foreclosures.
Foreclosures are bound to be higher at a time when house prices are falling and the EMI's are increasing. This cut in interest rates would lead to lenders lowering their PLR's and thus softening the relative impact of an interest rate reset. The lower lending rate could also spur new purchases of houses stabilizing the house prices.
Given this bleak scenario, the FED probably had no alternative but to cut interest rates and soften the impact. A 25 or 50 bps holds no relevance, I guess. It might need to do more if the problem worsens.
But does it alleviate the Credit market problem - ?
Risk aversion continues in the credit market with slack demand for structured assets. O/s Asset backed commercial paper (ABCP) issuance has dropped by 30.0% and rollovers are non-existent, indicating a lack of investor interest. So in such a scenario, does a rate cut help?
Look at it this way - the credit market problem was never a problem of borrowers; it was a problem of lenders. So if a lender was reluctant to lend at a higher rate yesterday, what is his motivation to lend today 50 bps lower??
The resurgence of the asset backed market is crucial for the housing activity. Mortgage lenders need MBS buyers. With the current risk aversion scenario, the appetite for MBS tranches of sub-prime borrowers seem remote. In 2006, Sub-prime, Alt-A and Home equity loans accounted for 50% of total mortgage loans and a substantial chunk of it was packaged and sold off as MBS.
Moral Hazard -
On the other hand the rate cut opens up the question of 'Moral hazard' - i.e by cutting rates, the FED is sort of bailing out the institutions and funds. As one Bank of Tokyo economist put it the FOMC now stands for 'Friend of the Market Committee'. There are concerns even on how the cut in rates could again spur the reckless lending in search for higher returns.
Where does all this leave us?
The markets are already pricing in further rate cuts by the end of the year. The rationale being that the FED has never in its history done a rate change and then sat still. They will follow it up with some more cuts.
Despite the 50 bps cut, future rate actions would be data dependent. This was an exceptional situation and with a 50 bps increase the FED has conveyed to the markets their concerns on economic growth being affected by problems in the financial markets. It would have to be data dependent going forward. A rough calculation on the normalized Fed Funds rate (as per the Taylor rule) points to a rate around 4.75%.
A big concern is inflation - dollar depreciation, oil and food prices should keep price levels under pressure. Also, recent retail sales and consumer confidence have been stronger than expected. Over and above that - US CPI Inflation has lot of positive base effects in the coming months. And even a stagnant index would lead to higher readings on the headline inflation.
We would go for a hold on rates in October for further clarity on the economic condition.
Would other Central Bank follow suit -
If not rate cuts, they certainly seem to have put on hold their tightening spree. The BOE and ECB held rates steady even before the Fed eased and the BOJ, which was most expected to raise rates, held steady today morning. The only major economy on a tightening spree is China.
But both the BOE and ECB are more inflation hawks than pro growth. The problems in the UK housing market has forced even the BOE to lend liquidity support and guarantee retail depositors. But we don't see any rate easing by the BOE and ECB in the short term. And also their economies weren't under as much stress as the US.
And the RBI?
Way to early to even think of a benchmark interest rate cut. The growth is strong, Credit off-take is picking up and concerns remain on inflation. Depending on the liquidity and credit off-take situation the RBI has the leg room to alter the CRR and the SLR ratios in the coming months.
Indian markets and Asset prices -
NO surprises from the way Indian asset prices would move post the rate cut. Equities are up 3.5%, the rupee at 40.25 is down 25 paise from yesterday's close, Indian long bond yields are down 5 bps and so is the swap curve.
The cut is seen to be alleviating the credit problem and also increase liquidity leading to higher flows in to emerging markets and thus to India.
But we believe that the long term impact of the sub-prime problem would be a reduction in leverage levels. Northern Rock, the UK mortgage lender, in a liquidity mess now, has an equity base of ₤3 bn and an asset base of ₤113 bn. Leverage of 37 times!! Most of the US and European investment banks also have leverage of around 20 times. Hedge Funds have known to leverage around 15-20 times on their capital. The industry would move to tighter lending standards over time and central banks would tighten prudential norms. This would impact the overall levels of leverage and liquidity.
Remember -
Leverage = Liquidity!!
Via Arvind Chari- Fund Manager, Quantum Liquid fund