A Post Rate Cut World

Here are the key issues I am following after the Fed Rate cut earlier this week:

• Dollar Devaluation: The US Dollar has taken a big hit on the back of the 50bp FF rate cut on Tuesday. For the first time in 30 years the loonie (Canadian Dollar) reached parity with the USD. The Euro broke through the key psychological level of $1.40 as it continues to rally against the dollar. The trade weighted dollar index dropped 1% to 78.5. Here are some other highlights from the dollar devaluation:
• Saudi Arabia: SAMA, Saudi Arabia's monetary agency, took no action after the Fed rate cut signaling that it might be considering dropping its peg to the US dollar. While this alone wouldn't crush the dollar there are concerns that sentiment is slowly switching among central bankers the world over how tied they want to be to a slowing US economy.
• Greenspan: Alan Greenspan has been hogging the spotlight with the release of his new book and his prognostications on the economy. According to Alan the odds of a recession are "somewhat more" than 1 and 3 even after the Fed rate cut. Alan also appeared
  on the Daily Show on the same day the Fed cut rates . . it yielded quite an interesting interview.
• 
  
• Commercial Paper: Many market participants have been tracking the commercial paper market to gauge the health of the credit markets in general. We have had 5 straight weeks of declines in commercial paper outstanding for a total decline of roughly 16%. The decline has been led by asset backed commercial paper (ABCP). After the declines slowed the past few weeks they picked up this week though the cause of the shift is largely due to a decline in supply instead of a decline in demand.
• Financials: In the face of strong headwinds Goldman Sachs put together a strong quarter, with a 79% surge in net income. Goldman is now the only major bank that is in the black on the year, up almost 3% on the year. Bear Stearns didn't fare quite so well, watching its net drop 61%. Its stock is off almost 30% on the year.
• GSE Portfolio Caps: President Bush and OFHEO reversed tack and allowed Fannie and Freddie to raise their loan capacity by 2% for a total increase of $34 billion. The change should help relieve some pressure on the mortgage market but isn't a quick fix.
  
• Middle East Sovereign Wealth Funds: Dubai purchased a stake in OMX and Nasdaq. Qatar purchased a 20% stake in the LSE. Abu Dhabi purchased a $1.75 billion stake in the management company of private equity firm Carlyle.
• Rally in the AAA ABX Indices: After briefly being down over 10% on the year the AAA ABX index has rebounded nicely off of its yearly lows.
  
• Stabilization in the BBB Rated ABX Indices: The BBB rated indices are still trading down 70% this year but look steady at current levels.
• Barack Obama's Rough August: Jim Simons and Mark Carhart aren't the only ones who had a tough start to August this year. If you track Barack Obama's likelihood to be the Democratic nominee for President on InTrade you may have noticed the Barack Obama had a rough start to August this year, falling from a virtual dead heat with Hillary Clinton into a distant second place.

Fed Funds Rate Cut to 4.75%, Discount Rate at 5.25%

After much speculation in the financial press and on Wall Street the Federal Reserve cut the Federal Funds rate to 4.75%. The Fed also lowered the discount rate to 5.25% keeping the spread between the FF rate and the discount rate at 50 bps. Fed Funds futures projected a 42% chance of a 25 bp cut and a 58% chance of a 50bp cut, though most economists predicted a 25 bp cut. In what is sure to be a very controversial move the Fed pursued a drastic policy action that may look to many as if it is seeking to "bail out Wall Street." Concerns about the strength of the economy will also be heightened as the Fed took a dramatic step today to ease in the face of a prolonged credit crisis and housing downturn. The broad market indices were up this morning on positive earnings from Best Buy and Lehman and should finish strong on the Fed's decision. You should also look for the USD to weaken further against most major currencies on recession concerns.
Here is the text from today's Federal Reserve Statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4%.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee's last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric Rosengren; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 5-1/4%. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, St. Louis, Minneapolis, Kansas City and San Francisco."

There are dramatic changes in the release compared to August 7th's Federal Reserve Statement:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth was moderate during the first half of the year. Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.

The Fed statement changed dramatically in the 6 weeks since the last release. Gone is the language about inflation moderation being "convincingly demonstrated" and gone is the emphasis on inflation as the "predominant policy concern." The Fed is clearly at the beginning of an easing cycle, though they emphasized the need to monitor incoming information and tried their best to warn investors that they are taking a balanced view on the prospects for inflation and economic growth.

I was personally quite surprised by the unanimous vote. The previous four Federal Open Market Committee meetings yielded unanimous votes to hold rates. The last time the FOMC failed to produce a unanimous vote was back on December 12, 2006 when Jeffrey Lacker advocated a 25 bps increase in the FF rate. That vote was one of a series of 4 straight votes that Lacker broke from the group in seeking to raise rates. But in light of the credit market conditions and uncertainty about the economy it definitely surprised me that between Thomas Hoenig and William Poole we didn't get a single vote for a 25 bps reduction in rates today. I expect a deluge of articles in coming days about moral hazard concerns and the perception that Bernanke is yielding to pressure from Wall Street and incumbent politicians who are hoping for a strong economy going into an election year.

A Phantom Rate Cut

The Federal Reserve sets the Fed Funds Rate and uses open market operations to keep the rate as close to the targeted rate as possible. The targeted rate has been set at 5.25% since July of last year. Since then 14 months have elapsed and the daily effective federal funds rate over those 14 months has been kept incredibly stable. In fact in 8 of those months the effective rate was exactly 5.25%. In 3 of the months the effective rate was 0.01% above the targeted rate and in 2 of the months the effective rate was 0.01% below the targeted rate. All in all, the New York Fed did a phenomenal job of controlling the rate using open market operations.

Then came August . . .

Somehow the effective federal funds rate in August was 5.02%. This would be fine if the Fed had cut the targeted rate to 5%. Yet the targeted rate still sits at 5.25%. Much has been made in the blogosphere of this "phantom" rate cut. And much of what they say is true: in reality, even though unannounced, the markets have had their rate cut for over a month. In fact if the Fed fails to cut rates on September 18th and we see the effective rate drift up towards 5.25% again that will be the equivalent of a rate increase . . . something the markets would undoubtedly not respond well to!

You can check out the effective federal funds rate data yourself on the Federal Reserve website.

The CRE "Earthquake"

I have been warning about the impending collapse in the commercial real estate world for quite some time (in May, in July). Recently more and more anecdotal stories about continued softening in CRE seem to be coming in. This most recent one is from Law.com:

The sudden queasiness of lenders has cast a pall over the once-robust real estate market in the last six weeks, Cowan and other lawyers report. Deals have been interrupted mid-stride. Some have been re-jiggered and others have just died.

With the pop of the housing bubble and the implosion of the subprime mortgage market, lawyers representing homebuilders had already seen a slowdown in transactions. But with the credit crunch that followed, high-end commercial real estate deals -- the cash cow for big-firm real estate groups -- aren't going forward.

Although the dead deals haven't come close to killing the practice, they have taken some life out of the legal fees. Some clients demand discounts from 5 percent to 15 percent if a deal doesn't go through, lawyers report.

While I don't think this is a doom and gloom report, I think this does lead one to become more and more concerned about the health of the CRE market. A good question to ask would be who would get hurt the most if the CRE market went into a tailspin?

Mankiw's Taylor Rule

Harvard economics professor Greg Mankiw came up with a simple equation in a 2001 paper entitled "U.S. Monetary Policy During the 1990's" as a proxy for the Fed's Taylor Rule. The equation was originally developed as a best fit for monetary policy during the 1990's. However, even today it seems to be doing a fine job of predicting the direction of interest rate movements. Here is the equation:

Federal funds rate = 8.5 + 1.4 (Core inflation - Unemployment)

Courtesy of Crossing Wall Street: "In July, the unemployment rate was 4.647% and core CPI was 2.210%. That translates to a Fed Funds rate of 5.088%, which is below where the Fed is now. Here’s a look at how the Mankiw Rate compares with the real Fed Funds rate over the past few years":

I think the fact that the Mankiw rate was above the real fed funds rate from 2001-2006 is telling. Some have argued that the housing bubble was largely the result of the fed funds rate being held too low too long by Greenspan. Greenspan's defense was that a "risk management" approach was necessary to avoid the risks of a deflation.

Interestingly, at the Federal Reserve Bank of St. Louis' annual symposium at Jackson Hole Harvard professor and NBER chief Martin Feldstein defends Greenspan's risk management approach and is currently arguing for a full 1% rate cut in coming months.

On the other hand Stanford economist John Taylor (author of the Taylor rule) argues that "a higher funds path would have avoided much of the housing boom … The reversal of the boom and thereby the resulting market turmoil would not have been as sharp.”

As is evident in the debate between Feldstein, Taylor and others, the jury on Greenspan is still out. As the economy unwinds after years of easy credit Greenspan's policies in the early part of the decade will continually be under the microscope.

El-Erian Returns to Pimco

After just 2 years at Harvard, Mohamed El-Erian is returning to Pimco as Co-CEO and Co-Chief Investment Officer. His short stint at Harvard was successful, but now the door is open again for a new face to run the $34.7 billion endowment:

Sept. 11 (Bloomberg) -- Mohamed El-Erian unexpectedly resigned as head of Harvard University's $34.9 billion endowment fund to return to Pacific Investment Management Co., manager of the world's largest bond fund, as co-chief executive officer.

The 49-year-old executive, who led Harvard Management Co. to its best results in seven years after taking over in February, 2006, said in a statement that he was returning to Newport Beach, California-based Pimco to be closer to family members.

Harvard recruited El-Erian in October 2005 to fill the void left a month earlier by the departure of 15-year investment chief Jack Meyer, who left along with almost three dozen Harvard officials to start a Boston-based hedge fund. El-Erian rebuilt the staff and guided the endowment to a 23 percent gain in the fiscal year ended June 30, adding $5.7 billion to the world's biggest university endowment.

``Mohamed has done an impressive job guiding and reorganizing Harvard Management Co., and we will miss his leadership,'' said James F. Rothenberg, treasurer of Harvard University and chairman of the fund's board. ``In addition to achieving excellent investment returns, he has led ambitious efforts to rebuild HMC during his time as CEO.''

At Pimco, El-Erian will be co-chief executive officer and co-chief investment officer, starting in January, the Newport Beach, California-based fund said in a statement. El-Erian, a former managing director and senior portfolio manager at Pimco, will share the CEO position with Bill Thompson and the top investment job with company founder Bill Gross.

Emerging Markets

Rothenberg said a search for El-Erian's replacement will begin promptly. Harvard Management, founded in 1974, invests about half of the school's endowment and oversees external managers who handle the remainder.

``Obviously we would prefer that he stay longer, but HMC is in great shape,'' Harvard spokesman John Longbrake said in an e- mail. ``In 18 short months, HMC has completed the transition and rebuilding phase and established conditions for sustaining superior returns over time.''

El-Erian was considered one of the world's most influential emerging-markets managers when he was hired by then-Harvard President Lawrence Summers. He had been a Pimco managing director for six year, overseeing $28 billion in bonds of developing nations and their companies when he left.

IMF Background

Previously, El-Erian spent 15 years at the International Monetary Fund, rising through the ranks to become a deputy director. He left in 1997 and was a managing director at Salomon Smith Barney before joining Pimco, a unit of Munich-based insurer Allianz AG. El-Erian's name was put forward in 2004 to be the IMF's managing director.

Meyer left Harvard to form Boston-based investment firm Convexity Capital Management LP, taking more than 30 Harvard managers and other employees with him. The departures included almost all of Harvard Management's internal bond investors.

El-Erian said he wouldn't let Harvard become overly reliant on a single team or strategy again. He cut the fund's traditional dependence on bonds, shifting more assets to buyout funds and non-U.S. markets. He also hired senior managers from Stanford University, Deutsche Bank AG and elsewhere.

In the most recent fiscal year, the only full one under El- Erian, the fund had its best performance since 2000, recording its fourth-best increase since the management company's founding in 1974.

``Harvard has been fortunate to have someone as skillful and effective as Mohamed El-Erian responsible for the management of our endowment,'' said Drew Faust, Harvard's president since July 1, in a statement. ``It will be a top institutional priority to do all we can to ensure that HMC continues to deliver superior investment returns with a focus on advancing Harvard's educational mission.'

Subprime Mess: More Fallout and One Potential Cure

In case you were wondering, the global credit markets aren't out of the woods yet. The London interbank offering rate, or Libor, is a widely used benchmark rate on everything from "adjustable rate mortgages in the US to giant floating-rate bank loans taken out by global corporations." How important is Libor?

Financial contracts with values of about $150 trillion are indexed to the Libor, according to a paper published in May last year by Donald MacKenzie, a sociology professor at the University of Edinburgh.

Yes that is $150 trillion with a T. So naturally an increase in the 3 month US Dollar Libor from its relatively narrow range earlier in the year does not bode well for the market. After spiking up in early August LIBOR appeared to be moderating, but has since reached a 7-year high at 5.72% after 10 straight days of gains. Economist Lou Crandall of ICAP in New York had this to say about the change:

"Higher Libor rates affect the whole economy by tightening the budgets of borrowers large and small. It hurts corporate profits and tightens household budgets, too."

This is hardly encouraging news for an economy seeking to find its footing and avert a recession. This becomes just another reason the Fed may have to loosen rates, though it is looking more and more like our problems will not be solved by a monetary solution.

At least a few people however are doing their best to find solutions instead of just pointing out problems. I stumbled across a post on WSJ's Deal Journal that had a rather interesting idea for how to restore liquidity to the debt markets. I'll let you decide for yourself if it is feasible:

Wall Street firms got into the pickle they are in now by doing deals that eliminated companies from the public scene. Now there is talk that to get out of the mess, they could create one.

As we discussed in this Ahead of the Tape column in The Wall Street Journal today, between now and the end of the year the firms must find somewhere to put more than $350 billion of loans and bonds, much of it from leveraged buyouts. With investors showing little appetite for the paper, there is a new theory circulating among bankers about the creation of a new company to house the debt that can’t find a home in the market.

Below is a bit more detail on how it all might work, according to a few bankers we spoke with, followed by some major caveats.

The banks would come together to create a new company we will refer to as LoanCo (though we can think of a lot of more colorful names, many of them with bathroom references). They would dump into the new company all the tranches of debt they are unable to sell to investors. These would include, say, a slice of covenant-lite loans from TXU and a pik-toggle bond issue from First Data.

Feel free to read on.

The Age of Turbulence

Alan Greenspan's new book -- The Age of Turbulence -- comes out on September 17th. September 17th is significant for another reason however; it is the day before the next Federal Reserve meeting. This meeting might well be the most important of Chairman Ben Bernanke's tenure for a couple of reasons. First, this is the first time in over a year the consensus is that Chairman Bernanke will lower rates a quarter point to 5%. Second, this is the first Fed meeting after the credit crisis and represents the first major opportunity Bernanke has to distinguish his policies from those of Greenspan (namely on the Greenspan put issue).

The result of the meeting remains to be seen. But, one thing is for sure, with $100,000 speaking engagements, lucrative consulting arrangements (with the likes of German giants Deutsche Bank and Allianz's Pimco) and a healthy $8mm advance for his new book, Greenspan is finally cashing in on all those years he put in at the Fed. Surely Bernanke can expect similar treatment at the end of his term.