Volatile January ends on an up-beat


US Federal Reserve Policy

The news of the month was an "emergency" cut of 0.75% in the Fed Funds rate on January 22nd, followed by an additional 0.50% cut on January 30th, for a total of 1.25% in a week.  This is the largest reduction in the Fed Funds rate ever.  By comparison, the Fed cut rates 0.50% after the 9/11 attacks, 0.375% after the October 1987 stock market crash. 

What made the Fed move so aggressively?  The Fed's January 30th statement cited "considerable stress in financial markets and tighter credit for some firms and households."  The statement also mentioned "a deepening of the housing contraction as well as some softening in labor markets."  While it is true the latest jobs report showed gains of only 17K jobs, the unemployment rate dropped to 4.9%.  Housing numbers have been terrible, but that been well known for months.  GDP dropped dramatically from 4.9% in Q3 2007, to 0.6% in Q4, but the contraction was entirely in construction - exports have surged. 

The one factor that is out of bounds with previous experience is the continuing global "margin call."  Too many banks, brokers, hedge funds, both US and international, own too many illiquid securities with too much borrowed money.  Collateral originally valued at par (100) is now marked down to 80, 60 even 40.  Fixed income securities, outside of conventional treasury or agency bonds, trade rarely, so their valuations have to be imputed from models.  The fastest way to goose the model is to drop the treasury curve yields, which are inputs into these models, and that what this 125 basis point cut has achieved.

The Fed has come under a lot of criticism for not acting faster and "being behind the curve."  However, the blame for the current crisis clearly lies in the hands of the managements of hundreds of private firs who chased after leveraged returns without regards to the risks.  As we mentioned previously, we think the Fed wouldn't mind if a couple of banks were forced out of business (to remind the rest to do their jobs.)  However, by mid-January, it looked like the global financial system was facing a "death spiral" of forced liquidation of loan collateral leading to plummeting prices, leading to more margin calls, and so was forced to act.