I thought the Dire Straits’ anthem of the 1980s, “Money For Nothing,” would be fitting for an article discussing Tuesday’s historic move by the Federal Reserve. Inflation be damned, the central bank lowered its target rate to a range of zero to 0.25%
The Federal Reserve is taking a very firm stand. Bankers are laying down the gauntlet with a policy that will do everything in its power to fight the evil deflation that has permeated the economy.
All cards are now on the table. Will it be enough?
Positive Market Reaction
The market cheered the news. The Dow jumped more than 150 points in the immediate aftermath of the news and added another 100 points during afternoon trading. By the time the bell sounded to close the day , the Industrial index was up more than 350 points.
The Nasdaq and S&P 500 indexes were up even more. On a percentage basis, both gained more than 5% on the day.
Fed Pulling Out All the Strings
Along with the record low interest rate policy, the Federal Reserve stated that it would be using unconventional methods to fight this battle. The purpose of such a pronouncement was meant to let market participants know that a zero interest rate was not the firing of the last bullet.
Included in the unconventional tools will be the purchasing of mortgages from Fannie Mae and Freddie Mac as warranted. The idea here is to dramatically lower mortgage rates for consumers. Mission accomplished as mortgage rates fell after the Fed announcement.
Investors are gladly buying into the euphoric concept of a market savior. The only problem is that once deflation takes hold, it will be very difficult to break.
The Root of the Problem
While it is true that owning a home with a high interest mortgage can be refinanced to a lower rate, assuming there is a lender willing to do so, the problem is that in some cases home values have dropped well below the amount of the mortgage.
Interest rates are not the problem here. The problem is a balance sheet issue that only time and restructuring can fix. Unless these refinanced mortgages include write-offs of principal, the problems will still exist.
While it is encouraging that the central bank is doing all it can to fight this battle, to think that the problems will be solved in the short-run is naïve. Even those crafting the policy insist that it will take time to work through these issues.
Why Foreclosures Are a Good Thing
The reason this will take time is that nobody likes the idea of writing down assets. Banks on the hook for the lending don’t want to write down an asset as long as a customer is paying. The home owner doesn’t want to write down the asset by selling at a lower price.
This is a version of economic stalemate. Nobody makes a move. People sit on the sidelines twiddling their thumbs.
What will break the stalemate? Well, it was foreclosures that moved the ball during this first go around, and it is looking more and more likely that it will take increases in foreclosures to push asset values to the point needed for sustainable growth.
In a way, the good news is that foreclosures are expected to push higher in 2009 as no-interest rate loans convert to market rates or higher.
It has been suggested that such pressure will cause another wave of foreclosures. This time around, the event would bring prices to the point that triggers more activity on the buy side.
The good news is that when that moment occurs, the Federal Reserve has in place tools that will help on the buy side. Only then will an all-clear sign be given.
Which Way Will the Market Go?
The market clearly believes that all of this will take place in a short period of time — no more than six months down the road. As such, they are bidding up stocks, and they are doing it when the news coming from corporate America and the economy is negative.
I’m hedging my bets by keeping my model portfolio 75% invested in stocks. I can deploy the 25% cash sometime during the first quarter of 2009. I advise against trading this market at the moment unless there are specific names that can be exploited.
This article was written by Jamie Dlugosch, contributor to InvestorPlace.com. For more actionable insight like this, go to: www.InvestorPlace.com. James F. Dlugosch contributed to this article.
