Economic & Market Update: October 6, 2008

“The Voyage Begins”

Chip Norton, Managing Director of Fixed Income & Economic Analysis

Last Friday, the House finally passed the Emergency Economic Stabilization Act. While the bill is certainly a bit longer than the original, it appears to have the things needed for Treasury Secretary Paulson to begin his plan. This entire situation seems similar to a great voyage on the sea. Yes, we have the ships and they are provisioned well, but we’re beginning our sail right in the middle of a hurricane. It will be a tough journey ahead, one with many challenges and one that voyages into uncharted territory.

Paulson’s challenge will be to effectively manage the plan in a very smart and timely manner.  He’s at least smart enough not to use the bureaucracy crowd in Washington to execute his program. Reports suggest he’s going to hire at least a dozen managers to help implement the plan. Firm names already surfacing are Goldman (surprise, surprise), PIMCO, Legg Mason and Blackrock. He hired his former colleague, Edward Frost, who’s now Harvard’s executive vice president and overseer of their huge endowment. Bill Gross of PIMCO is also reported to be on board with the program, along with Charlie Clough, former head at Merrill and Fidelity superstar Peter Lynch. Some on the Street are already calling this yet to be named team the “Dream Team.”  Indeed, it will have to be such a team to navigate through this mess, but with the power of such a team the odds seem greatly in favor of a successful outcome.

Of course, some would say that every private sector team member presents a conflict of interest in that they will all benefit from this plan, but the reality is that every American will benefit from the success of this program. The plan must succeed and, in the words of the Apollo 13 mission, “failure is not an option.”

In the near-term, this market will continue to see volatility as the entire world market adjusts to an environment of uncertainty. Even today’s market open looks bleak, with significant downside from Europe as the banking community there experiences the same pressures that are seen here in the US.

Pressure on the Fed to Lower Rates – New Measures, Again

In response to the turmoil over the last week most market players are nearly screaming (we usually save that for Jim Cramer, don’t we?) for the Fed to lower rates. With the current fed funds rate at 2.0% the thinking is a cut of at least 50 bps in the near-term is warranted. Indeed, the fed fund futures implied probability suggests almost an 80% chance of a rate cut at the next scheduled meeting on October 28th. However, the Fed certainly doesn’t need to wait until then to act.

The market is currently pricing the highest probability of a cut of 100 bps. As you can see from the chart below, there is a 40% chance that the funds rate moves to 1.0%, and just a 20% chance it stays the same at 2%. Here’s the funny thing about the futures market- it’s not always correct. Just a few weeks ago, the market had all but cemented a big rate cut from the Fed, yet Bernanke and the FOMC stood firm at 2.0%. They elected to use liquidity measures outside the fund rate to provide liquidity. Some suggest that the Fed wants to at least have some dry powder to deal with market extremes if and when they occur.  Some on the Street say the Fed should use a trick from Detroit and have 0% financing for the next six months! Crazy talk, or a novel idea? Try this one:

It was announced this morning that the Fed would begin to pay interest on excess reserves held by member banks. In addition, it is, yet again, expanding the TAF auction amounts.  Here’s the comment from the Fed:

“The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions' required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

Consistent with this increased scope, the Federal Reserve also announced today additional actions to strengthen its support of term lending markets. Specifically, the Federal Reserve is substantially increasing the size of the Term Auction Facility (TAF) auctions, beginning with today’s auction of 84-day funds. These auctions allow depository institutions to borrow from the Federal Reserve for a fixed term against the same collateral that is accepted at the discount window; the rate is established in the auction, subject to a minimum set by the Federal Reserve.

In addition, the Federal Reserve and the Treasury Department are consulting with market participants on ways to provide additional support for term unsecured funding markets.

Together these actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit. The Federal Reserve stands ready to take additional measures as necessary to foster liquid money market conditions.”

Substantial Further Increases in Term Auction Facility Auctions:

“The sizes of both 28-day and 84-day Term Auction Facility (TAF) auctions will be boosted to $150 billion each, effective with the 84-day auction to be conducted Monday.  These increases will eventually bring the amounts outstanding under the regular TAF program to $600 billion. In addition, the sizes of the two forward TAF auctions to be conducted in November to extend credit over year end have been increased to $150 billion each, so that $900 billion of TAF credit will potentially be outstanding over year end.”

Employment Weak

Last week’s employment data did the market no favors, with 159, 000 jobs lost and an unemployment rate of 6.1%. Only the government sector added jobs. The job loss data, as we have been saying here for some time, is critical in the economy’s recovery. With the issues in the financial markets taking center stage, consumer confidence has waned and spending showing signs of weakness. This does not bode well for the upcoming holiday spending season which starts in just six weeks. Hard to believe we are talking Christmas shopping already but, in my local market, some shops already had Christmas buying events. This speaks to the concerns of small business across the country as they struggle to find financing for inventory and attract customers in such stressful times.

Lighter Side: September Madness

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