Why Interest Rate Cuts Might Not Help This Time

The financial markets, instead of enjoying the usual lazy, hazy days of summer, got hit by the credit market crisis that could have marked the end of the five-year-long bull market. The collapsing prices of junk debt securities, including those backed by U.S. subprime mortgages, in some cases bankrupted dozens of financial institutions in North America as well as overseas.

While the latest data on the U.S. economy shows no sign that the economy may be sliding into a recession, the White House and the Fed are obviously worried. Last Friday, in what appeared to be a coordinated effort, the President and the Fed’s Chairman issued statements designed to restore confidence in the financial markets and a reassurance that all available means will be used to avoid a market melt-down and a recession.

So far their policy statements have been short on specifics, though both made the point that whatever steps are taken they are not meant to rescue Wall Street gunslingers from the abyss created by their own reckless greed. This being a pre-election year, the President’s call to bail out homeowners from losing homes (that they could not afford and should not have bought in the first place) will surely be echoed by all the presidential hopefuls.

While it remains to be seen what the President’s rescue plan will involve, one thing is certain: it will be the tax payers who will ultimately pick up the bill for the irresponsible decisions of individual home buyers and the financial institutions that financed them.

When it comes to the steps the Fed is bound to take, cuts in the federal fund rate are what investors and Wall Street have already taken for granted. So far, the Fed has resisted the cries for this monetary medicine favored and generously dispensed by the Fed under Al Greenspan’s chairmanship. Rather surprisingly, Ben Bernanke dusted off a policy tool that the Fed frequently used back in the 1960s and 1970s: the discount rate. On August 17, the Fed cut the discount rate, the rate at which banks can borrow from the Fed, from 6.25% to 5.75%. Such loans are typically secured by treasuries. Notably, the Fed also announced that this time it would accept a broad range of lower grade collaterals, including home mortgages and related assets.

By cutting the discount rate rather than the federal fund rate, the Fed avoided appearing to flip flop, in a panic, only days after issuing a benign statement from its August 7 FMOC meeting: “Although the downside risks to growth have increased somewhat, the Committee’s predominant concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.”

Investors, instead of waiting for the Fed to cut the federal fund rate, rushed into the safety of high-grade debt, reducing treasury yields across all maturities. The decline on the short end was especially extreme. For example, the yield on 90-day T-bills dove from 4.8% on August 8 to as low as three percent on August 20. Though declines were less dramatic in mid- and long-term treasuries, the yield on 10-year treasuries also declined substantially from 4.85% to the recent 4.54%.

Recent history suggests that Wall Street’s wish for a cut to the federal fund rate to give fresh legs to a geriatric bull market could turn out to be a case of ‘be careful what you wish for.” During the January 2001-October 2002 stock market decline, it took 12 consecutive interest rate cuts before the devastating bear market finally ended. Subsequently, starting July 2004, the Fed hiked its rate 17 times while the S&P 500 still added another 38% to its previous gains.

The reduction in interest rates, as already implemented by the market itself, was very selective, being extended only to high- grade debt securities. At the same time investors, shocked by the collapse in junk debt, are demanding higher interest rates on higher risk securities. That will make financing of leveraged buyouts much more expensive, cooling down the LBO mania that has been one of the biggest factors driving stock prices relentlessly up in the last two years. With LBO activity cooling, and thus demand for many stocks, cuts by the Fed in interest rates this time around may not be enough to get the stock market rally really going again.