The Federal Reserve meets on 18th September to decide on US base rates which currently stand at 5.25%. Given the backdrop to this meeting it is hard to overstate its significance. The financial futures markets are discounting 0.75% off base rates by end-2007 and we look for a full 1.0% reduction by end-Q2 2008. The last piece in the jigsaw is likely to be Retail Sales data for august due for release today (Friday 14th September).
After the awful payroll data expectations for an aggressive 0.5% point reduction in rates increased sharply, however, since then Dr Bernanke has given little away. A closely watched speech in Berlin said little about the health of the domestic economy but his comments on global economic imbalances were interpreted as dollar negative. US consumer confidence remained unchanged at -17 as consumers appeared indifferent to rising gasoline prices and falling employment. Slightly concerningly, the data also showed respondents’ view of the economy actually improving slightly (-32 to -34) while the outlook for retail sales improved (-30 to -28). This may point to a slightly more robust retail sales number which is forecast at 0.5% (+0.2% ex automobile sales).
The consequence of stronger retail sales data might be to provide the hawks on the Open Markets Committee with sufficient ammunition to vote for a mere 0.25% cut in rates or even less, a move which would be greeted with dismay by the markets.
How equity markets perform in the wake of the first cut in a monetary cycle has come under some scrutiny in recent weeks. According to analysis by Credit Suisse, since 1984 equities have rallied 100% of the time over the month following the first Fed rate cut in a cycle, but only 80% of the time in the following 12 months (the exception being 2001).
Disappointingly, the analysis does not stretch back to 1981, the last time the US experienced a deep recession driven by weakness in the consumer sector. How robustly equities perform tends to be a function of the size of the Fed’s move. A 0.75% point cut (by the end of the year in which the first rate reduction took place) has only happened during the relatively light recession of 1991 and the Long Term Capital Management inspired crisis of 1998.
Although there are marked differences between the prevailing economic cycle and that of nine years ago the one likely similarity is that equities are only likely to respond favourably the more aggressive the rate reduction is. As we note above, the futures markets have got the bit between their teeth and any indication that expectations are to be disappointed would almost certainly be met with a negative response.
In our view the, possibly temporary, revival in equity market confidence may be sufficient to encourage the apparently cautious Dr Bernanke from making an aggressive move at this forthcoming meeting. Thus while we call for aggressive monetary action over the next nine months we anticipate a muted start to the process. What happens next will depend entirely on subsequent economic data releases and the response to that data on the part of monetary policy makers.
Alternative 1 (40% probability)
1998 all over again. The Fed cuts base rates by 0.25% points in response to weak employment data but given that this amounts to disappointment in the financial markets volatility levels increase. The background risk is that ensuing economic data disappoints and the crisis in the credit market remains significant. In such a scenario the Fed, having hinted that monetary policy could be eased in the light of further information, follows up its first rate cut with a further rate reduction at its next meeting. Such an outcome would be greeted positively, assuming that the accompanying statement indicates the Fed’s preparedness to act again. High beta to do well.
Alternative 2 (25% probability)
The Fed cuts base rates by 0.25%. A benign retail sales data release gives the impression that the crisis affecting the financial markets is containable and unlikely to spread to the wider economy, despite the poor non-farm payroll data. The Fed reiterates its view that there is little wrong with the structure of the global or US economies. The banks are given time to reveal the extent of their exposure to the credit market and the crisis recedes. Generally speaking, the prolongation of uncertainty in the near-term is hardly the stuff to get investors onto their feet. Such an environment encourages the view that the equity market recovery will be slow.
Alternative 3 (25% probability)
We ascribe an equal probability to alternative 2 to the possibility that the “pushing on a string” argument. Given that the Fed’s own survey concludes that it was not lower rates but attractive offers which tempted sub-prime borrowers to enter the property market, it is tempting to wonder whether cutting rates, at the same time as tightening lending criteria will make any difference at all. Clearly this alternative, implying quite clearly that the financial market crisis transforms into an economic crisis is the worst case scenario. In such an environment it is hard not to see a situation in which equities struggle and defensive investments such as short dated Treasuries and cash prove popular.
Alternative 4 (10% probability)
The Fed decides to take no action at all in an attempt to avoid criticism pertaining to “moral hazard”. Given the extent to which the futures market is pricing rate cuts into expectations this decision would be greeted with dismay and much would then depend on subsequent data releases to bail the Fed out.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley