Issue 39 - October 2, 2007

Trick or Treat

Given the market volatility of the first nine months of the year, it seems appropriate that the Federal Reserve has scheduled its next meeting on Halloween. After credit tightening and margin calls catalyzed a summer sell-off, September saw a strong recovery from oversold conditions across most major asset classes. The Federal Reserve chose to reduce the benchmark rate by 50 basis points at its September 18th meeting sparking quarter-end rallies in stocks, commodities, and short maturity US Treasuries. The US Dollar continued its slide as a result of these lower interest rates and now stands at multi year and in some cases, all time, lows. While the committee was certainly aware of the currency risk of a lower rate environment, they deemed the risks to credit and economic growth as a more pressing matter. Much debate surrounded this particular decision. While there were voices in favor of all conceivable actions, the Federal Reserve was not presented with much in the way of good choices.

The goal of monetary policy sounds simple enough: “to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” As we mentioned in our previous letter, the Federal Reserve had used low interest rates as its dominant tool to address economic disruptions in the modern era. The “moral hazards” that developed as a result of these policies were certainly deemed to be a lower priority in light of the more immediate concerns. However, many of these hazards were front and center in the most recent credit unwinding and the new chairman had to weigh the risks of repeating old sins in an effort to maintain their mandate. The easing has led to a long awaited normalization of interest rates which will provide a significant benefit to the major banks who will continue to be the main player in this brave new world of traditional credit requirements.

Dispersion

Markets reacted favorably to the recent cut in the benchmark rate. While the US Dollar has drifted lower, stocks, bonds, and commodities have risen, in some cases sharply. The immediate investment themes have favored growth over value, large cap over small, and oil and gold over anything else. With two remaining FOMC meetings left in the year, the expectation of further rate cuts dominates. Lower interest rates might provide a nice floor under the PE of equities, but the real key will be individual corporate earnings. Just being a large cap company will be no guarantee of stock out performance any more than being a small cap will guarantee disappointment.

The latest cut in rates spurred a rally in short term rates that has left the US Treasury yield curve positively sloped across the board for the first time since the Federal Reserve began normalizing rates. However just as
an inverted curve was not the harbinger of a recession, this environment will still have to contend with the unwinding of unwanted mortgage and asset backed securities. As risk was re-priced this summer and liquidity returned, long-term high grade bonds became very attractive on both a relative and an absolute basis.

The housing markets in the most effected areas will take some time to heal. But as we see here in our own neighborhoods, real estate is a local phenomenon and not every area is declining. There will be a deflationary impact from housing on the overall US economy which will mix with the inflationary effects of higher energy and commodity prices and a weaker US Dollar. While this has provided the Federal Reserve the necessary cover to lower rates right now, the inflationary forces are likely to be with us for a long time. The overall impact of all these swirling forces which have recently been released will take a little while to settle down into more discernable trends.

Outlook

Historically it was said, ”When the United States sneezes, the world catches a cold.” As the US economy slows over the coming few months, this old adage will surely be put to the test. The global growth story has not been derailed by the US housing market and the willingness of the Federal Reserve to take steps they deem necessary should provide a reasonable backdrop provided we maintain our long term focus.

• Trick or Treat
• Dispersion
• Outlook