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Monday January 28, 2008 - 16:24:10 GMT -

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Stimulus Package Weak at Worst, Uncertain at Best

Roller coaster ride set to continue

You would certainly be forgiven if you’re feeling a bit like Linda Blair in ‘The Exorcist’ after this week’s market moves. I think my head has spun around at least twice in as many days and I reckon there are a few more spins ahead at the minimum. Markets are very fluid and there are a lot of important events coming up next week, but let me first try to put some of the events of this past week in context before delving into what lies ahead.

Last Friday I wrote that investors had turned outright defensive based on deteriorating global growth expectations and a sense that a US downturn was unavoidable. This week then began with an equity market meltdown that sent other riskier assets plunging as well, most notably the JPY-crosses. On Tuesday morning, the Fed unexpectedly jumped into the fray, undoubtedly based on the turmoil in financial markets (I’ll get to the rogue French trader later), and cut the Fed funds rate ¾% to 3.50%. Stocks struggled a while longer, but eventually rebounded. The rebound came on curious news that the NY state insurance regulator had convened discussions with major banks to shore up the capital of beleaguered bond insurers. The rebound in stocks and risky assets continued on Thursday as news of a US economic stimulus package emerged, only to then sputter on Friday, casting doubt on the rebound overall.

I would suggest that the balance of risks and the deteriorating outlook favor further waves of market liquidations rather than a sudden emergence into stability, much less continuing recovery. First, judging by the initial market reaction to the Fed rate cuts—further declines—it’s clear to me that investor pessimism still runs deep and that lower interest rates alone will not fix the problem. Second, the ostensible cause of the impressive late afternoon rally—potential capital infusions for bond insurers—highlights ongoing credit market concerns that still lie at the root of the current market turmoil. It’s highly uncertain whether a capital infusion plan can be worked out to forestall downgrades to the major bond insurers, which would result in ratings downgrades to the bonds backed by the insurers, leading to an unprecedented exodus of capital from such investments. That is the biggest fear lurking in the hearts of investors everywhere.

Third, global markets moved in tandem in what was surely one of the most volatile weeks in financial market history. I take that as further evidence that the risks emanating from the US are going to have repercussions globally and that the global investment environment remains highly unsettled. That goes back to the underlying credit market concerns, which expose investors and institutions all over the world to heightened downside risks. Finally, price action in the major stock indexes, commodities and currencies all suggest that a return to normalcy is far from nigh. Attempts by stocks to extend gains failed on Friday, generating a ‘spinning top’ pattern on the weekly candles, signaling indecision, while the daily candles look set to post a ‘bearish engulfing’ line, suggesting the rebound has already ended. Adding all these elements up, I remain convinced that further market implosions remain more likely than not and this view favors selling riskier assets (JPY-crosses, stocks, gold, and oil) on strength.

All eyes on the Fed next week

The Fed surprised markets by reacting to severe equity market declines on Monday, damaging its credibility in many respects, and throwing expectations for next week’s FOMC decision into a blender. In the immediate hours following the surprise 75 bp rate cut, expectations were for a further 75 bps next week, but that was pared down to 50 bps as stocks recovered further, and fell to 25 bps as stocks peaked on Friday morning. Going into the Friday close with stocks set to close down, expectations have shifted back toward 50 bps (70%) vs. 25 bps (30%). In my mind, there also exists the very real possibility that the Fed stays on hold, having already delivered what it thinks is the ‘substantive, decisive, timely’ relief to the economy.

For the Fed to have cut rates just 8 days before a scheduled meeting suggests it was pushed by market developments, a position no central bank likes to be in. The meager recovery by financial markets since then clearly signals investors need more interest rate relief and that leaves the Fed in the awkward position of kowtowing to markets further or risking another financial market meltdown. Finally, the news that SocGen suffered a $7+ bio loss on unauthorized trading raised the scenario that the stock market sell-off was precipitated by the exiting of those failed positions, potentially leaving the Fed without a true rationale for the 75 bp cut. But the Fed has indicated it was unaware of the SocGen situation, the verity of which the market will debate for months to come. If policymakers feel they were duped by one-off market events, it argues for holding steady. But given the balance of risks, I’ll go with a 70% chance for 25 bps and a 30% chance of steady.

Obviously the market reaction to the Fed’s decision is going to be critical to the near-term trading outlook. I think it’s safe to say that a steady rate decision will see a massive sell-off, a 25 bp rate cut a heavy sell-off, and a 50 bps rate cut could go either way, but most likely up on the back of financials. If the Fed cuts 50 bps and stocks don’t rally, then the situation is going to get much worse before it gets better.

US outlook remains weak, will drag on global growth expectations

The US outlook remains extremely weak with analysts only debating the extent of the impending slowdown. As we saw two weeks ago, global markets are acutely sensitive to reductions in global demand and growth, especially with most major commodities still trading at or near all time highs. Gold has made another attempt to rally beyond the 914 level, but at the close of Friday, the rally looks to have been rejected soundly, and a doji pattern was generated on the daily candles. The doji and rejection from above recent highs further suggests that the rebound from $850 (which I targeted in last week’s report) has already ended, leaving a double-top in its wake.

ECB officials have scoffed at the market’s expectations that the ECB would cut rates in tandem with the Fed, but time is on the market’s side. Eurozone growth forecasts are continuing to be downgraded as fears of a global downturn take root. European sentiment has already plunged and it’s now left for that to translate into lower real consumption and slower growth. Several major European banks just this week have changed their forecasts for steady ECB rates throughout 2008 and are now expecting two rate cuts. European financial institutions and credit markets are still reeling from the US sub-prime meltdown and credit conditions remain tight as shown by ongoing ECB liquidity operations. Dwindling Eurozone growth and interest rate outlooks will continue to weigh on EUR keeping it a sell on strength.

Stimulus package uncertain at worst, weak at best

The US economic stimulus package announced late this week is already facing difficulties, as Senate leaders appear unhappy with many of the package’s details and may delay its passage or alter it to a point the White House finds unacceptable. The political pressure to pass a stimulus bill will be intense, so it seems likely some compromise will be reached. But even then the logistics of distributing cash to consumers represents another hurdle that may delay payments until well into 2Q, damping the near-term outlook even further. Finally, the details of the package suggest it may not have the desired effect even if it is enacted in timely fashion. The tax rebates are primarily targeted at better-off consumers, who may not immediately spend it, blunting efforts to prop up consumption. The rest of the package is tax cuts targeted at businesses to promote investment and hiring, but given the deteriorating outlook it remains to be seen whether firms will take advantage of such tax breaks. The jury will be out on the stimulus package for quite a while and that suggests it will not provide the desired impact, keeping the near-term outlook decidedly negative.


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