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This time is not different - at least not in terms of the initialinvestor response to an unexpectedly aggressive Fed rate cut. But I'mnot convinced that the Fed's move makes a material difference to therisk of recession, which is the decisive issue for medium-terminvestors. A few thoughts:
First, rate cuts are like tequilashots: You rarely have just one. Morgan Stanley US economist RichardBerner expects the FOMC to ease by a cumulative 100 basis points. Theprospect is underlined by the second-round collapse in housingindicators. For example, Reality Trac reported overnight a substantialjump in housing foreclosures in August (Exhibit 1).
Second,equities usually perform well in the initial stages of a Fed easingcycle. Morgan Stanley European strategist Teun Draaisma has provided anice summary of past equity performance around the first Fed cut (seeStriking Statistics, 17 September). Teun notes that historically thefirst rate cut may only stabilize markets, while better returns followthe second easing. Rightly, however, Teun notes that it's not a stretchto argue that the discount rate cut was the first easing in this cycle.
Third,equities are a sell in extended Fed easing cycles. That's becauseextended easing cycles usually occur in recessions, and recessions arealways bad for equities. But even within recession-driven bear markets,Fed rate cuts can provide a short-term boost for the market,particularly if they are unexpected. Amidst the TMT rout of 2000-03,the NASDAQ jumped 14% on the day of the first (surprise) Fed cut in2001. Of course, in a bear market, it pays to sell such bounces.
Withthe daily run of economic data soft, but not providing compellingevidence of recession, my base case assumption is that the Fed easingwill provide support for equities in the next quarter or so. Formedium-term investors, however, the key issue remains simple: Is the USheading into recession?
A few comments on that big-pictureissue. First, I think it's noteworthy that having now marked the top ofthe tightening cycle that started in 2004, the funds rate has followedthe pattern of lower lows/lower highs evident since 1980 (Exhibit 2).To me, this is important evidence that in a world of rising leverage,monetary policy packs a bigger punch. More to the point, the profile ofsuccessively lower lows in nominal rates suggests to me that the ratecuts in this cycle will extend further than most expect.
Second,in this cycle, the recession risks are centered in the householdsector; last time it was the corporate sector. The household sector isnow the highly indebted/cash-flow-negative sector. (And, as with thecorporate sector in 2000, the household sector's balance sheet - atmarket values - now looks fine.) More than usual, consumer-related datawill provide the clearest guidance on the recession risk.
Third,I believe that in this cycle the benefits of looser monetary policywill not be easily transmitted to the household sector. This is thereverse of the last recession. Uniquely, the household sectoraccelerated its borrowing through the 2001 recession: Exhibit 3 showsthe change in household debt, both in four-quarter change terms andrelative to disposable income.
The bulk of household debt ismortgage-related, most of which remains tied to long-end rates. Theboom in borrowing through the last downturn reflected the fall inlong-end rates and the willingness of households to refinance theirmortgages. Ten-year Treasury yields hit their cycle low in June 2003 at3.1%. That means, however, that the key to providing renewed monetarystimulus to households is getting long-end rates down to levels thatmake refinancing again attractive. To do that, long-end rates need tofall significantly from current levels (Exhibit 4). As it turns out,10- and 30-year Treasury yields rose after the Fed cut last night.
Inthis context, the important 'credit crunch' is not what is happening inthe land of high finance, or commercial paper, but the tightening inmortgage lending. Exhibit 5 shows a selection of mortgage ratesrelative to long-end Treasury yields. Not captured here is the factthat mortgage finance is simply not available for a range of borrowersthat did have access through the past few years. Also not captured hereare the prospective mortgage resets that mean that, notwithstandingtoday's Fed rate cut, many borrowers face a material tightening in'monetary policy' in coming quarters.
In short, it's my viewthat this Fed easing cycle will have less impact than the usual cycle.Certainly, today's move does little to change what I consider thefairly high risk of recession in 2008. That, in turn, fits with my viewthat any near-term rally in stocks will be one that investors have tosell into on a 12-month view.
Courtesy Gerard Minack Morgan Stanley Sydney
First, rate cuts are like tequilashots: You rarely have just one. Morgan Stanley US economist RichardBerner expects the FOMC to ease by a cumulative 100 basis points. Theprospect is underlined by the second-round collapse in housingindicators. For example, Reality Trac reported overnight a substantialjump in housing foreclosures in August (Exhibit 1).
Second,equities usually perform well in the initial stages of a Fed easingcycle. Morgan Stanley European strategist Teun Draaisma has provided anice summary of past equity performance around the first Fed cut (seeStriking Statistics, 17 September). Teun notes that historically thefirst rate cut may only stabilize markets, while better returns followthe second easing. Rightly, however, Teun notes that it's not a stretchto argue that the discount rate cut was the first easing in this cycle.
Third,equities are a sell in extended Fed easing cycles. That's becauseextended easing cycles usually occur in recessions, and recessions arealways bad for equities. But even within recession-driven bear markets,Fed rate cuts can provide a short-term boost for the market,particularly if they are unexpected. Amidst the TMT rout of 2000-03,the NASDAQ jumped 14% on the day of the first (surprise) Fed cut in2001. Of course, in a bear market, it pays to sell such bounces.
Withthe daily run of economic data soft, but not providing compellingevidence of recession, my base case assumption is that the Fed easingwill provide support for equities in the next quarter or so. Formedium-term investors, however, the key issue remains simple: Is the USheading into recession?
A few comments on that big-pictureissue. First, I think it's noteworthy that having now marked the top ofthe tightening cycle that started in 2004, the funds rate has followedthe pattern of lower lows/lower highs evident since 1980 (Exhibit 2).To me, this is important evidence that in a world of rising leverage,monetary policy packs a bigger punch. More to the point, the profile ofsuccessively lower lows in nominal rates suggests to me that the ratecuts in this cycle will extend further than most expect.
Second,in this cycle, the recession risks are centered in the householdsector; last time it was the corporate sector. The household sector isnow the highly indebted/cash-flow-negative sector. (And, as with thecorporate sector in 2000, the household sector's balance sheet - atmarket values - now looks fine.) More than usual, consumer-related datawill provide the clearest guidance on the recession risk.
Third,I believe that in this cycle the benefits of looser monetary policywill not be easily transmitted to the household sector. This is thereverse of the last recession. Uniquely, the household sectoraccelerated its borrowing through the 2001 recession: Exhibit 3 showsthe change in household debt, both in four-quarter change terms andrelative to disposable income.
The bulk of household debt ismortgage-related, most of which remains tied to long-end rates. Theboom in borrowing through the last downturn reflected the fall inlong-end rates and the willingness of households to refinance theirmortgages. Ten-year Treasury yields hit their cycle low in June 2003 at3.1%. That means, however, that the key to providing renewed monetarystimulus to households is getting long-end rates down to levels thatmake refinancing again attractive. To do that, long-end rates need tofall significantly from current levels (Exhibit 4). As it turns out,10- and 30-year Treasury yields rose after the Fed cut last night.
Inthis context, the important 'credit crunch' is not what is happening inthe land of high finance, or commercial paper, but the tightening inmortgage lending. Exhibit 5 shows a selection of mortgage ratesrelative to long-end Treasury yields. Not captured here is the factthat mortgage finance is simply not available for a range of borrowersthat did have access through the past few years. Also not captured hereare the prospective mortgage resets that mean that, notwithstandingtoday's Fed rate cut, many borrowers face a material tightening in'monetary policy' in coming quarters.
In short, it's my viewthat this Fed easing cycle will have less impact than the usual cycle.Certainly, today's move does little to change what I consider thefairly high risk of recession in 2008. That, in turn, fits with my viewthat any near-term rally in stocks will be one that investors have tosell into on a 12-month view.
Courtesy Gerard Minack Morgan Stanley Sydney
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