In 1998 the US Federal Reserve cut base rates by an initial 0.25% in the immediate aftermath of Long Term Capital Management's collapse, only to discover that a sanguine market had anticipated more, so the Fed acted again shortly afterwards. Who is to say that we might not get a dose of the same medicine this time around?
Although wary of drawing too many parallels with nine years ago we do find ourselves wondering whether, in the wake of Ben Bernanke's speech at Jackson Hole on 31st August, the Fed will give the market (judging by the Futures pricing of US Fed Funds rate expectations) what it wants. A 25 basis point cut has already been fully discounted ahead of the forthcoming Open Markets Committee meeting thus such a decision might end up making little difference.
The essence of the Fed's difficulty is that the equity market has stabilised in the wake of the turbulence of late July / early August. The restoration of calm might have encouraged US monetary authorities to hold fire on the basis of ongoing underlying concerns regarding incipient inflationary pressure. Indeed Dr Bernanke specifically mentioned that "It is not the responsibility of the Federal Reserve nor would it be appropriate to protect lenders and investors from the consequences of their financial decisions".
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However, he continued to echo comments made in earlier FOMC statements indicating ongoing preparedness to take additional action should it be needed to ensure the provision of liquidity to the markets. In such circumstances the futures market positioning appears appropriate.
It is also worth noting that Bernanke's position is a political appointment and with more than half an eye on presidential elections in November 2008 the present incumbent appears to be under no such constraint. Without providing any specifics the President extended an olive branch to all mortgage borrowers in delinquency, although throwing money at sub-prime borrowers would be unlikely to make much progress through the quagmire of an over-loaded legislative pipeline and a Democrat controlled congress. We take the view that the sub-prime issue has not gone away (it may be that we have to wait until Q3 2008 before the full extent of past excesses is known in full) and that the flailing of a lame duck president is unlikely to have any more than the mildest marginal impact even if it were to pass through the legislative process.
Bernanke is right to point out, as we have always maintained, that what started as a sub-prime problem has become a problem for the financial markets across many asset classes with a strong sense of impending inevitability. Meanwhile back in the real world Merrill Lynch reports that the average house price in California is $500,000 and thus does not conform to agency standards, classified as it is as a "jumbo loan" (above $417,000). Loans of this size have suffered what amounts to a 100 basis point increase in interest rates over the past month alone! Inevitably, this raises the strong possibility that this key state could be on the verge of a recession and raises further doubt regarding the validity of economic growth forecasts.
The IMF itself, an organisation well known for its ability to drive the global economic car using the rear view mirror, has admitted (in a 2003 study) that on the twenty occasions identified between 1970 and 2002 as being characterised by the deflation of various asset price bubbles, growth in the real US economy slowed from c3.4% before the asset price deflation, to just 0.8% afterwards. For context, the US economy grew at an annualised rate of 2.3% over the first half of this year.
Whilst the Fed may well opt to tread the middle ground at its next rate setting meeting on 18th September, cutting base rates by 0.25% to avoid any allegations regarding moral hazard, we suspect that this move could be the first of a number. Futures pricing indicates the market split between a quarter and a half percentage point rate reduction at the forthcoming Open Markets Committee meeting and given that the ripple effect from the financial market crisis is likely to take a while to impact the real economy we fully expect output growth disappointments to be the trigger for an aggregate 100 basis point base rate reduction between now and Q2 2008, although whether it makes much difference to the "pushing on a string" fraternity remains to be seen!
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley
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