Market Update
Dwight Johnston
Vice President, Economic & Market Research
Reality Bites
Most of the recent economic data has been almost shockingly weak. The headlines accompanying most releases typically read “Biggest Decline in 25 Years!” While most of the stock market’s woes can be traced back to huge forced selling by hedge funds, pensions, insurance companies, etc., the denial phase that the economy was weakening in the face of a major credit crunch ended. In September it seemed that the stopper was pulled out of the bathtub, and all the rubber duckies hit the dry, barren bottom of reality.
Throughout past crises, the consumer could always be counted on to soften the blow. But the consumer came into this crisis with the highest debt burden in history and limited access to credit. In 2005-2007, consumers took out more than $2 trillion from home equities. So far this year, a mere $58 billion has been cashed out. But consumers have turned to credit cards in a big way. In the ten months between September 2007 and July 2008, consumers increased card balances by $29 billion. In the ten weeks between July and mid-October, balances grew by a huge $32 billion. This isn’t going for extras though. McDonalds was the number one place for card usage. Buy a Happy Meal and pay it out over time. During the past year, as credit card balances have grown, the delinquency and charge-off rates have doubled. The consumer is in a bad place with no obvious way out but the painful one—less spending and paying down debt.
The FOMC cut the fed funds rate twice in the month of October. After the October 8 cut to 1.50 percent, a lot of us thought the FOMC would take to the sidelines and await weaker economic data in 2009. The credit market freeze did start to thaw during the month, and there appeared to be no reason for the FOMC to move further. But the stock market had other ideas. At the time of the regularly scheduled FOMC meeting on October 29, the stock market had seen a 25 percent decline for the month of October alone. The big rally the day before the FOMC cut that loss back to 18 percent, but some of that big gain was due to the expectations of another rate cut. Ben Bernanke has shown a propensity to dance to the stock market’s tune, and he did so again. But Bernanke’s move was based on more than the stock market.
Back in 2003, Ben Bernanke was on the Board of Governors at the Fed. He was the cheerleader for driving rates lower to ward off any risk of deflation. He trotted out studies of Japan in the 1990s and declared the Fed should stand ready, able, and willing to cut the funds rate to zero percent and maybe even buy securities in the market to pump more money into the system. For some of you that got stuck in 1.50 percent, three-year agencies at the time, this might be a bitter memory. Although the Core CPI is still 2.4 percent, Bernanke is looking at a global economy on the retreat and disastrous plunge in commodity prices. The plunge in commodity prices is more a function of the commodity bubble bursting than a pure demand driven move, but Bernanke doesn’t seem to get that. This means he is not interested in “reserving” room to cut rates further. As he sees it, he still has room.
The lesson here is to expect even lower short-term rates and a lasting period of those rates. Although spreads between the treasuries and certificates (agencies too) have started to come in, spreads are still extremely wide historically. The last time fed funds were one percent, that three-year certificate or agency was roughly 1.50 percent. Today, with funds at one percent, the three-year certificate is 3.40 percent. This sure looks like a gift to me.
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