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Viewpoint: Next steps for the Fed and the markets

Tom Sowanick

29 August 2007

Having trimmed the discount rate, the Fed want to hold off on federal funds. Tom Sowanick is CIO of Clearbrook Research, part of Clearbrook Financial, a Princeton, N.J.-based wealth-management service provider.

The Federal Reserve's decision to lower the discount rate by 50 basis points on 17 August 2007 has had several effects. First, and perhaps most important, the financial markets have stabilized. Volatility, as measured by the VIX Index, has fallen 40% and three-month Treasury bill rates have risen from a panic low of 2.7% to a somewhat more rational 4.6%: 40 basis points lower than the 5% level that preceded the Fed's discount-rate decision.

Credit spreads have stabilized and there is evidence that investors are now looking at the corporate-bond market as a source of value once again, at least in the investment-grade arena. The S&P 500 Index has rebounded from a low of 1,370 to a current reading of 1,472 for a gain of 7.4%. Share prices for banks, brokerages and some mortgage companies have also risen sharply from depressed levels.

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While a sense of calm has returned, it is clear that investors have been jolted by the losses associated with sub-prime related assets.

Whether investors were being greedy and opportunistic is not the question. Rather, one should ask why the engineers and packagers of these products were willing to sell these assets to investors but not willing to provide liquidity when it was most needed. Pointing fingers at mortgage lenders is insufficient. Wall Street and the rating agencies should take some of the blame for their role in packaging so-called AAA-rated paper and rating these products as if they truly were AAA.

Lowering the discount rate from 6.25% to 5.75% has restored order to the financial Markets. But it has also spawned cries for more action.

Clearbrook Research believes that Fed shouldn't heed those cries. Specifically it shouldn't yield to pressure by cutting the federal funds rate. Lowering rates when investment vehicles prove to be less than pure investments would establish a bad precedent. Anyway, who would actually benefits from a cut of 25 or 50 basis points in the federal funds rate? If Wall Street is unwilling to bid on bad paper then what will a 50 basis-point cut achieve -- other than lowering all money-market yields?

The Fed, and investors, also shouldn't dwell too much on federal funds futures contracts. During periods when markets are negatively affected by outside events, these contracts often react violently and then return to pre-event levels. The most recent example was last spring when China's equity market dropped 9% in one day and the response was for an almost immediate re-pricing of federal funds futures contracts. The September contract fell from 5.20% on 22 February to 4.9% on 7 March before gradually inching back up to 5.25% this month.

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A review of last spring's events reveals that once it was clear that the Fed would hold rates steady, stocks started their ascent to new all time highs and bonds suffered significant losses. In fact, despite recent market turmoil, total returns for the bond market, as measured by the Treasury bond market, have gained only 1.7% since 7 March while stocks have advanced 6.5%.

The big risk, however, isn't that the Fed lowers rates on next month, but that investors become too defensive and will not be rewarded even if the Fed does cut rates. Investors who have moved to the front end of the yield curve are now most vulnerable to a whiplash if official rates remain steady.

From a strategic perspective, credit spreads have most likely embarked on a long-term path of wider spreads, as risk pricing continues to normalize. In other words, moving up in credit quality and also into short-dated maturities should be maintained for a considerable period of time.

While short-dated Treasuries would be vulnerable if rates remain steady, the longer term trend is for the short-end of the yield curve to provide higher total returns than long-term maturities as the yield curve gradually gets steeper. It's important to recognize that this process could take several years before it's completed.

Markets in Germany, parts of Asia, and the BRIC nations -- Brazil, Russia, India and China -- should continue to outpace U.S. markets. Though we continue to expect the U.S. equity market to lag many of our trading partners, we also strongly believe that U.S. and global stocks will outpace returns from bond markets.

So, despite all the recent turmoil, we strongly recommend overweighting equities versus bonds.

Steady

Our strategic view has not changed. Global growth appears strong, and liquidity is on hand for sectors that deserve it. Defensive strategies should Come into play for fixed-income allocations, but not for equities.

Many strategists argue that large-cap stocks are preferable to small caps, but we hesitate to paint with such a broad brush. We'd be more selective, favoring large-cap financials, industrials with heavy exposure to developing countries and the healthcare sector.

We believe the U.S. dollar is still trending down. The U.S.-dollar index is at 80.68: perilously close to its secular low of 78.82 . Lowering the federal funds rate would probably push the U.S.-dollar index to new all-time lows.

So Fed might want to see more economic data before it takes further action. Taking a breather would in fact give it a better chance of helping to stabilize financial markets and consumer confidence. -FWR

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