The Fed Cuts the Discount Rate

Good day… A Marvelous Monday! What a crazy week in the markets we had last week! I’ll start off with a brief description of a Bond Trader’s day on Thursday; just to show you how crazy his day was. This email was received from a former colleague of mine at the old Mark Twain Bank. He’s now a very important bond guy in Florida!

“You should have seen the mortgage market yesterday…collateral was gapping lower while treasuries were rallying through the roof…and just when you thought it was safe…collateral rallied through the roof…major whiplash…major pain…thank God we are light in inventory.”

And that story could be told on hundreds of trading desks, be they bonds, stocks, commodities, currencies, etc. But what happened to calm it down on Friday? Ah grasshopper… Remember on Friday I said that there were rumors of an emergency Fed meeting? Well… Those rumors came true, and the Fed decided that there should be a discount rate cut of 0.5%.

OK… Let me explain this discount rate thing. The discount rate is what the Fed charges for banks that need to borrow funds from the Fed. They call this having to go to the discount window. Now… Normally, if you need to borrow from the discount window, the Fed doesn’t take kindly to this. But if you need to go two times, then the Fed is looking into your books!

Well, this time, the Fed said, “Come on, borrow. And do it at a cheaper rate. We understand.” Now… The thing that scares me about this move is this: What if the Fed is repeating the bail out of the LTCM episode in 1998? What if the Fed is bailing someone out, that we won’t know about, until months later, like the LTCM episode?

Anyway… If it isn’t any of that scary stuff, then the rate cut is strictly a symbolic move, and should be looked at as a precursor to a Fed funds rate cut. And the markets took this as such… Stocks rallied… But so did the euro (EUR) and sterling (GBP) and the other currencies that had gotten sold earlier in the week. At one point on Friday the euro had gained back over one-cent!

And one more thing here… Isn’t life strange? A turn of the page… Just two weeks ago the Fed Heads would only talk about inflation fears, and now they have turned their backs on inflation to care about financial market stability. Hmmm… Didn’t know that was in their job descriptions!

Before I go on though, I want to remind everyone how my colleague Ed Bonawitz and I would sit with Hy Minsky, the famous economist, and listen to him explain economics. Ed reminded me on Friday of something Hy Minsky taught us, and it rings so true in these times.

“Remember Kindleberger/Minsky said it best, ‘All panics, manias and crises of a financial nature, have their roots in an abuse of credit.’ That held true in the 1600’s with the Tulip Mania as it does in the 21st century. We humans are doomed to repeat history. Over and over again!”

And don’t think for a moment that the cut by the Fed might have been the cure for what ails the markets… This was just a “relief rally” not a “recovery rally”. The problems of last week are still hanging around, and are far from resolved! Remember, the story I told you last week about Sentinel Management Group and how they were trying to block money market withdrawals? Well… They filed Chapter 11 on Friday.

Now… As I go along here… I see that the Asian stocks are soaring; and a high yielder, Aussie dollars (AUD), has rebounded. Hmmm… You don’t think, nah… Well, maybe… Yes, maybe baby, more carry trades are going on the books. Sure smells like carry trades doesn’t it? I sure wish the markets would make up their collective minds and get on with this unwinding and stop going back. The carry trade must be like a drug to the markets, and every time they get out of rehab, they fall right back into the clutches of this drug!

I’m happy that the Aussie dollar is recovering… But not to carry trades… If, in fact, that’s what’s happening.

Personally, I think that all we need is some stability in risky assets and current account surpluses and long term financing flows start to see the dollar drift lower in Asia again.

The data cupboard doesn’t have a lot to give us this week, although we do start the week out with the latest reading of leading indicators for July. The markets don’t usually pay attention to this data, and I do!

The last couple of weeks the markets were so tied up with liquidity/credit problems that they didn’t pay much attention to economic data. Let’s hope that all ends, and we can get back to fundamentals!

It’s a pretty quiet week in Euroland with regard to data prints too. We will see the latest ZEW Confidence number tomorrow… Industrial orders on Wednesday, and the latest Manufacturing PMI on Friday… And in Norway, we’ll see the latest GDP on Thursday… Other than that, we’re on our own!

For once the U. of Michigan confidence report told the truth! The index plunged to 83.3 for the first two weeks of August, a reading of 90.4 in July! The thing to remember here is that the survey was taken the first two weeks of August, when we were just heating up the liquidity/credit crunch. Imagine for a moment how bad this survey would reflect sentiment if taken now!

Before I go on to the Big Finish, I’ll leave you with a comment from overseas… France’s Econ-Minister Christine Lagarde commented this morning, “I think the worst of the crisis is behind us. I don’t exclude that, particularly in America, a number of funds could find themselves in difficulty, but this is a classic phenomenon of American finance which is often guilty of excess.”

So… At least someone thinks the “all clear” has been sounded! I’m having trouble hearing that though.

Currencies today: A$ .7985, kiwi .6970, C$ .9435, euro 1.3490, sterling 1.9810, Swiss .8280, ISK 67.60, rand 7.3650, krone 5.9250, SEK 6.9210, forint 192.10, zloty 2.8450, koruna 20.50, yen 114.10, baht 32.75, sing 1.5270, HKD 7.8160, INR 40.9650, China 7.5860, pesos 11.07, Silver $11.87, and Gold… $666.20

That’s it for today… I begin the third phase of my cancer treatment today… Cancer medicine. Depending on how well I tolerate it, I’m hoping to get back into the office soon… It all depends on how well I tolerate it. I have to get something off my chest here though… The medicine that I’m taking costs $22,000 for a three-month supply. Now, my insurance will pay this, but come on! This is a big part of the reason that over 60,000 people a year die from cancer. If they don’t have good insurance like me, or they don’t have the means to cover what the insurance doesn’t pay for, how can they have a chance to get cured?

What gives here? I’m not against big companies making money… But at the expense of people that need these cancer drugs? This isn’t an “optional” thing here! People with cancer have to take these medicines… Something should be done about this… And I’m firing a letter off to my congressman today! Maybe you will too!

Sorry… I really got off on that tangent. Today, is my darling daughter Dawn’s birthday… So happy birthday Dawn! I hope you and the rest of my dear readers have a Marvelous Monday!

Chuck Butler
August 20, 2007

The Daily Reckoning