Market’s Response To The Fed’s 25 Basis Points: Sell The News

``For us, the only good reason to accept risk is to achieve gains (in excess of risk-free Treasury bill yields) that we can reasonably expect to retain. This is a much different perspective than the one held by many speculators, who seem to believe that it is unacceptable to miss any rally. The problem is that it's futile to chase a rally unless you also have a reliable exit strategy.”-John Hussman, Hussman Funds

We expected the US Federal Reserve to cut rates by 50 basis points. Instead they delivered 25. Thus, global equity markets responded with a dramatic selloff. Since, as we earlier mentioned, the markets have been founded on the expectations of the provision of “steroids” from government intervention, the lack of element of positive surprise resulted to a traditional “sell on news”.

Our initial impression was that the Chairman Bernanke of the US Federal Reserve could have underweighted the risks brought about by today’s credit logjam. But this doesn’t tally with the FOMC’s accompanying statement (highlight ours), ``Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.”

So, while the Fed recognizes the underlying dilemma, they opted to act moderately for unspecified reasons.

Some analysts suggested that the Fed’s ambivalence could have been due to external pressures particularly from Central Banks, such as China. From Reuters (highlight ours), ``What I'm worrying about now is the weakening dollar and its potential impact on global growth. The dollar is the major currency for trade and its continuous depreciation will push up prices of global strategic goods such as oil and gold and reduce the wealth of dollar-holding nations," Vice-Commerce Minister Chen Deming said.

``So I want to see a strong dollar," Chen told reporters during a break in a two-day "strategic economic dialogue" near Beijing with senior U.S. officials led by Treasury Secretary Henry Paulson.

Since the motion of continuously reducing interest rates have been detrimental to the US dollar holdings of global central banks, then such decrials seem understandable.

On the other hand, others suggest that the Fed’s actions appear to be reflective of the reduced policy traction as LIBOR rates continue to rise as shown in Figure 1.

Figure 1: Northern Trust: LIBOR Less Target Fed Rates

LIBOR or London Inter-Bank Offer Rate as defined by investorwords.com is the ``interest rate that the banks charge each other for loans (usually in Eurodollars). This rate is applicable to the short-term international interbank market, and applies to very large loans borrowed for anywhere from one day to five years.”

So aside from interbank borrowing, LIBOR is a widely used benchmark for ascertaining most adjustable mortgage rates to rates of corporate loans to even government borrowing. Yet LIBOR is not determined by the Federal Reserve.

In other words, to quote Martin Weiss from Money and Markets, ``LIBOR is easily the single most important interest rate in the world…Even if the Fed lowered its target for fed funds to zero ... if the LIBOR rate fails to decline in tandem, or worse, actually goes up, the Fed's power to avert an economic decline in the U.S. will be shot to pieces.”

Hence the Fed’s tentativeness could possibly be construed as a deflection of its policies growing impotence over the ongoing debt and capital destruction or “deflationary process” in the financial markets.