Bull market corrections are usually based on a single, bizarre story the financial press keys in on, and after the sentiment storm passes we see it wasn't much to get riled up about after all. (See our past commentary, "Bad Conation" 8/13/07 for more.)
As such, we continue to believe today's fears of widespread economic meltdown stemming from illiquidity, credit crunches, or subprime mortgage woes are mere superstitions. See these past commentaries for our detailed thoughts on each:
• Debt Disambiguation (7/26/07)
• In the Meantime (7/31/07)
• Corrective Measures (8/3/07)
• No Credit Messiah Necessary (8/6/07)
• Fed Focus (8/16/07)
What better antidote for a superstition than an equally powerful talisman to ward off the demonic spirits? We generally only hear about talismans in legends and fairy tales—an amulet or trinket thought to be a protection against evil.
But we think today's surprise announcement from the Fed qualifies as talisman material too.
Today the Federal Reserve lowered its discount rate from 6.25% to 5.75% in response to current liquidity fears. The discount rate is the interest rate the Fed charges qualified lenders—mainly banks—for temporary loans. This move is largely symbolic and doesn't mean much for capital markets in general. For an in-depth discussion on what exactly the Fed discount rate is, see:
Explaining the Discount Window
the Editorial Staff, the Wall Street Journal (*registration required)
The central bank did not change its more closely watched federal funds rate, which affects rates consumers pay on various types of loans, including credit cards, home equity lines of credit and car loans. That rate remains at 5.25%.
In other words, particularly as it pertains to today's credit crunch fears—subprime mortgage debt, CDOs, and high yield debt in general—there is little effect. In fact, the discount window itself is very seldom used at all by banks to begin with.
Yet, stocks rallied furiously today on the news. In our view, this is a clear illustration of just how sentiment-driven markets are at the moment. This is the stuff of classic bull market corrections. The market's fretting largely baseless fears has been dampened by a talisman-like gesture which itself is profoundly inconsequential. Take a look at these headlines:
Fed Cuts Discount Rate, Acknowledging Need to Act
By Scott Lanman, Bloomberg
Stocks Rally After Fed Shifts Bias
By Joanna Ossinger, The Wall Street Journal
Based on this, you'd think discount rates have something to do directly with mortgage loans and high yield debt—that is, the credit crunch. But they don't. The discount rate is for banks that can't get access to liquidity any other way than going to the Fed. That's great if there are truly a number of financial institutions in distress. But even Countrywide, one of the premier toxic avengers of the mortgage loan market, was able to get access to over $11 billion in liquidity from a variety of private lenders earlier this week.
Our question is: Will anyone even bother to utilize this lower Fed discount rate right now? If so, who? The only reason would be if a bank can't get financing the good old-fashioned way through the cheaper fed funds target rate.
Against this backdrop, this is shaping up to be a truly shrewd move from our bearded friend Bernanke. The Fed today has reassured and soothed markets—giving them, at least in part, what they wanted (a rate cut). All the while, the Fed leaves its far more important target rate alone and keeps its inflation vigilance intact.
If the Fed were really concerned about liquidity they'd more likely move the discount rate below the target rate. That would suddenly make it cheaper for banks to simply pony up to the Fed's discount window and get a cheaper loan than the open market offers. But that just isn't the case.
Also, the notion that the Fed has "changed its bias" is probably erroneous. We'd argue just the opposite. We view the Fed's move, if anything, as an affirmation that inflation remains their chief concern and an adjustment in discount rates is all that's required.
After today's big rally …have we reached correction's end? Since corrections are sentiment-driven things it's impossible to say. Remember that corrections usually end as quickly as they began. But if the correction did end today, it would be a relatively short one—they usually go on at least a few weeks more than this.
Investors seem to be wearing today's Fed cut of discount rates as a magic talisman to ward off the credit crisis. We see it as a symbolic gesture to sooth the nerves of ill-founded fears. Either way, the fundamentals remain bullish, the Fed continues to be sanguine and steady in its very appropriate reactions to the current liquidity environment—and stocks look extremely cheap.
Have a great weekend.