Sunday, August 19, 2007

Fed Acts to Bail Out Banks

Welcome back to us, thank you. We had a good week off and could only watch the market from our vantage point near the TV, oh well. It was a wild week of volatility which the Fed capped with a loud clang on the bell. Apparently, the Billions of dollars of Repo’s weren’t enough. The Fed decided to act more publicly visible, a discount on the discount rate. What does this all mean?

The early Repo action was a little surprising but the discount rate move was almost a panic move on the part of the Fed. We believe the Fed has acted too soon but that doesn’t mean they will be successful at stopping what’s going on with the real estate market.

As you look at the Fed, many people figure they are part of the Federal Government but the fact is that they are Not part of the government. The Federal Reserve is the name of the Central Bank who seems to have the ability to control the money supply of the economy. If you think of the entire economy as being a board game like monopoly, then let’s put the Fed in charge of the money, as in the bank. As the game progresses, the bank is allowed to provide some money for passing Go or for various additional money distributions from drawing “Chance” or “Community Chest”. In the real economy, the Fed can buy property, too. When they buy “bonds” or “MBS’s”, they put money in the system. You might be asking, “So what?”

Well, with the power to put extra money in the system, the Fed can instantly change the situation for the banks. You see, it is the banks that the Fed is concerned about. Their job is to keep federal banks solvent but not tell them what to do, like what kind of credit risk to take on. Now, the world sees the Fed as the knight in shining armor riding in at the right time to save the day. Well, they may have saved Friday and part of Thursday afternoon with their rate cut but will it be enough to save all of the mortgage problems out there?

Of course, this discussion on the Fed is not why you came to the Update. You came here to find out what the market is going to do in the next few days, right? Well, as we write this evening, there is a large rally going on over in the Asian markets celebrating the Fed’s move on Friday so there is still some remnants of positive thinking in the world. You may recall that the Asian markets were closed before the Fed cut the discount rate so they are rallying now.

We here at the Wednesday Update consider the market has rallied 600 points from last Thursday afternoon to Friday so a huge amount of energy was spent to the upside already. Plus, last Friday happened to be options expiration and would normally be a high volume day with some price surprises. The market is Not done going down and no matter what happened last week there is much more downside to come. The timing of the downside may be sooner or later but it will probably not be denied even by the Fed’s actions. The Fed still seems to have some sway over the market but at some point, their power will diminish as they try and fail to stem the tide of selling.

We are somewhat cautious in our criticism of the Fed because they can be seen as just helping out the banks at this point. The change in the discount rate is a pure bank saving play. The Fed wants the banks to borrow money from them so more money can be “created” to provide more liquidity. This is supposed to be followed by more credit being built up. This is where the problem comes in, “Can the Fed create demand for credit with lower rates?” We will be discussing this topic over the next few days because this is real issue. The Fed thinks it can create inflation at will by lowering rates or providing liquidity. We are not so sure.

In other markets, the precious metals took a major dive on Thursday as the HUI index lost about 13% that day. As we have said, this index should go down even more before we get interested in it. Currently it is just over 300 so we need to see about another 10% drop before we start looking for bargains there. Likewise, the Treasury bonds got a big rally as the flight to quality grew last week. Friday was a rest day for the T-bonds due to the Fed Saving the day but there may still be some upside in the T-bond market.

1 comment:

Cianna said...

Good for people to know.