Overview: Cry Baby Cry

There is nothing worse than bankers’ tears. Those puppy eyes that water as they whimper about the cataclysmic downturn that lies on the horizon, unless the Federal Reserve slashes interest rates, is a scene that is now all too familiar. We are in a well-defined cycle that commences right after the FOMC meeting, when the market expresses its dismay with a paltry 25 bps reduction in interest rates by selling off in a fit of rage. This is followed by two weeks of temper tantrums, which include write-offs, profit warnings and pleas for the Fed to provide a more accommodative monetary policy. Scared to death by the juvenile behavior, the monetary authorities capitulate and preannounce a reduction in interest rates, sparking a rally that culminates with the FOMC meeting–when the cycle commences again. Like the crocodile tears of a toddler, the behavior works wonders with the monetary authorities. Unfortunately, with 325 bps to go before Fed Funds return to 1%, 10 FOMC meetings per year and a reduction pace of 25 bps per meeting, it looks like we better get use to bankers’ tears for the foreseeable future. The predictability of the market also defines trading patterns, which could prove to be very lucrative.

Wall Street bankers are the biggest cry babies in the world. Their vacuous eyes transmit an air of innocence as they countenance trillions of dollars in aggregate losses. It does not matter that they willingly leveraged the global financial system with unsustainable off-balance sheet liabilities. Their control of the rating agencies, manipulation of the media and influence over the hedge fund industry allowed them to act with impunity.Now, they face insolvency as the financial system falls apart.

Unfortunately, the recent monetary expansion and continued rise in commodity prices are creating inflationary pressures, thus putting the Fed in a precarious position–given that it is mandated to maintain price stability in addition to full employment. The Fed’s dilemma is exacerbated by the fact that the U.S. economy is slowing down at a gradual pace. Hence, this is why Wall Street bankers have become more strident in their warnings, in order to force the Fed’s hand.

The oscillation began on July 20, 2007, with the collapse of two Bear Stearns Hedge Funds. This sparked a 6% decline in the Dow. Fed Funds had been steady at 5.25% for a year, but the financial problems caused by the implosion of the housing bubble forced bankers to call for a reduction in interest rates. The market recovered more than half the ground it lost on the eve of the August 8 FOMC, but it plunged 6% when the Fed failed to act.

With the market down more than 8% since the onset of the crisis and political pressure mounting, Fed Chairman Ben Bernanke capitulated in mid-August by pre-announcing a shift in monetary policy. The Dow rallied 10% during the next two months. A 50 bps reduction on September 18 was seen as a portent of things to come. However, the enthusiasm faded in mid-October when the Fed suggested that it would hold rates for a while. A wave of profit warnings and write-offs were unleashed, provoking another 5% decline in the Dow. Hence, the Fed was forced to preannounce another reduction in interest rates. Unfortunately, the 25 bps reduction on October 31st was seen as too little, and the market lost 9% during the next three weeks, forcing the Fed to suggest more interest rates reductions. The subsequent rally pushed the Dow 8% higher, but the rally fizzled on the day of the FOMC. There was a brief pop at the end of the year when the Fed and ECB opened the liquidity taps, but we can expect more red ink as the market tries to scare the Fed before the January 30th meeting.

The market oscillation according to the FOMC calendar creates a well-defined trading pattern. It also means that the market will be range-bound for the better part of 2008 and first half of 2009-that is until Fed Funds fall to 1%. This is the reason why we believe that the downturn will not begin until next year. The economic momentum spurred by easy credit will take some time to wind down. Most of the construction projects that are in the pipeline will probably be completed. The recent housing data suggests that developers will continue building, and reduce inventory by slashing prices. The ripple effects will also take longer to filter down to the emerging market countries. Last of all, the vast monetary ammunition still available will give hope to the market. However, the true extent of the damage will become evident in 2009, and the market will then go into a downward spiral. In the meantime, we need to become accustomed to a long period of bankers’ tears and temper tantrums.