Monday, August 27, 2007

Am I wrong?

Am I wrong in being too bearish on the market? That markets have gone up in the last week after Fed cut its discount rate was expected. But is this crazy?

Markets are not stupid. Last year too in late July, markets started moving up after Ben Bernanke's testimony to the Congress, when the Israel-Palestine war was still on and oil was going crazy, and people were worried that Fed would raise interest rates again. Is it that even this year, a bottom has been set amidst the chaos, and markets are going up from here.

Why should one be bullish?

a) Fed will cut rates on Sep 18.
b) Global growth remains strong. This will be enough to offset any weakness in US housing.
c) US I-banks are well capitalized and they will be able to withstand the loan losses on the financing deals with PE players. All this deal financing issue is a temporary hiccup, and PE mergermania is soon going to be replaced by corporate mergermania and stock takeovers.

The most important question is - what will the Fed do? Will it cut or not? Lets consider the two scenarios:

Fed cuts: Considering that the 3 month T-bill is still yielding 4.5%, much below 5.25%, one can argue that credit conditions are still distressed, even though equity markets have moved up in the last week. So Fed should cut. (By Sep 18, this argument might not hold water. But lets assume Fed cuts). Markets rally on Sep 18.

However, BOJ also holds its next monetary policy meeting on Sep 18 and Sep 19. If markets stabilize by Sep 18 (and rally on Sep 18 because Fed cuts), BOJ will in all likelihood raise rates on Sep 19, after having decided not to raise it last week due to worsening global conditions.

The dollar-yen carry trade will get whipsawed on both sides. If Fed cuts and BOJ raises rates, the interest differential between USD and Yen has narrowed by 50bps - a very significant amount. The risk to unwinding dollar-yen carry trades is indeed high then.

Fed doesnt cut: Considering that Fed futures are pricing in a 100% probability of a rate cut, markets will surely dive if Fed doesn't cut.

Considering Fed doesn't like to surprise markets, I think a Fed cut is certain, simply because Fed futures are pricing in 100%. It will not help Fed's credibility if they say we are not cutting, markets seize up again, and they end up again lowering the discount rate or the Fed funds rate.
But one can also argue Fed won't cut. Things have only improved since they cut the discount rate. So then why should they cut the Fed funds rate? It is very tricky this time.

But whatever they do, I think there is a high likelihood that markets get whipsawed on Sep 18 and Sep 19.

Over the next 1 year, I think the US housing market will take its toll. This is US housing - the biggest category of US aggregate wealth. It will have lost 10% of its value by next year. Why will this deflation not spread to other asset classes? With a lot of mortgage bankers in bankruptcy now, the fight for market share has gone down => crazy mortgages are gone. Plus rates just went up in August - the impact of which is going to come after a few months. I dont think a 25 or 50 bps cut by the Fed will save housing from here. The Fed needs to cut steeply if it has to save housing. But that will risk inflation and declining dollar.

Maybe I am wrong and it will all turn out to be fine. After all, the people at Fed have spent their lives with this stuff, while I have been reading this only in the last 3 years. Lets see how this evolves.

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