9/13 Toby Hansen - The case for a Fed rate cut Tuesday, September 16th

The case for a Fed rate cut Tuesday, September 16th

Some will probably think I’m crazy but I’m making the case for a Fed rate cut on Tuesday. Over the last year I’ve been able to predict the Fed would do something unusual with interest rates about 50% of the time prior to the event happening. My primary tools have been watching unusual movements in the gold and commodities market. Despite going out on an extreme limb and the absence of experts calling for it, I believe the Fed will aggressively cut rates Tuesday. Here are my reasons:

1. It was the middle of July when IndyMac bankruptcy was announced (Friday July 11th) and the Fannie Mae/Freddie Mac made new lows (Monday the 14th). Beginning on July 15th gold, oil and their producer equities made their high water mark and have since been sold off in violent fashion; quite similarly to March when the Bear Sterns was taken over. This second takedown in the commodity complex illustrates the beginnings of a pattern: when financial crisis becomes acute; trash commodities. While the first commodity sell off in March was painful, the second take down since July has been extraordinarily brutal sending many prices tumbling. It appears there is a secondary purpose in mind with the most recent sell off.
2. The US dollar went from nearly challenging its all-time low mid-July to rallying 13% over 80 today. This has occurred with no back drop of interest rate increases, in an environment of poor US economic data, falling US bond yields making them less attractive to foreign investors, record US budget deficits and an unprecedented potentially a multi-trillion dollar bailout of Fannie Mae and Freddie Mac. With the US dollar comfortably out of danger of going into a currency crisis, the stage now has been set that an interest rate cut won’t devastate the currency.

USDX Chart:

http://stockcharts.com/h-sc/ui?s=$US...
p06475580727&a=112138636&lis...

1. We saw how the Fed will come in to save the broad markets in January of this year. I remember it well as I was up at 4 AM CST watching the Dow futures being down over 1300 points. Before market open, the Federal Reserve cut interest rates 0.75% followed by a 0.25% cut the week after. The Dow subsequently gained 1500 points over the next few months.

Today approximately seven weeks away from US elections, the Dow sits near multi-year lows. Most voters decide who they are going to vote for in September and October. Should the Dow print under 10,000, many pundits have alluded that the Republican Party would become a near extinct species on Election Day.

Dow Short Term,

http://stockcharts.com/h-sc/ui?s=$IN...
&dy=0&id=p59328343045&a=...

Dow Medium Term,

http://stockcharts.com/h-sc/ui?s=$IN...
0&id=p27573491325&a=14372606...

If the Fed is going to cut rates prior to the US election, it should be Tuesday. Their next meeting is October 29th, six days prior to the election. For them to cut and have the markets rally six days before, would clearly signal their interference in the elections as opposed to now where other things can be used as an excuse. Cutting Tuesday will be a big boost to the broader equity markets and should have a positive lasting effect to get the markets through the election.

1. The banking industry is in deep trouble. Lehman Brothers, Wachovia and Washington Mutual are seeing their stock prices evaporate. Most people thought that the Fed reducing rates down to 2% was to bring down mortgage rates. Actually it was to make banks money. Until Fannie/Freddie federal takeover was announced, mortgage rates stayed put under the influence of the 10 Treasury note yield, not the Fed Funds rate. The Fed by reducing their rates has allowed banks to make money. Banks early on began to borrow at 2% and buy 10 year Treasuries at 4.2% yielding a spread of 2.2%. Late summer the long bond yield has fallen to 3.6% cutting banks spreads by 0.6% or a reduction in income of 14% from several months ago. Now is not the time for these spreads to narrow just when the banking industry needs cash the most.

This alone may be the sole reason the Fed will cut rates Tuesday. If they cut 1% for example, short term borrowing rates will drop to 1%. Due to the inflationary implications of pushing real rates more negative the 10 year note will likely soar to 4%. Hence, by simply cutting the Fed Funds rate, bank yield differentials will go from 1.6% to 3% for an increase of + 78% in a single day! A huge increase in bank income would likely rally the bank sector and allow them to sell equity to shore up their balance sheets.

1. The last major reason I believe the Fed will cut rates is due to the trade in gold and oil. If the Feds would have cut rates in mid-July at the fevered pitch of Indy/Fannie/Freddie, oil would be well on its way to $200, gold to $1200 from their prices of $145 and $980 respectively. The US dollar would have made new all-time lows. This would not be a politically or economically viable solution. The US dollar falling to new lows would also cause other economic pain. I believe that the trade was arranged to decimate the commodity sector while other central banks intervene in the Forex market to boost up the US dollar. The reason for doing this is it gives the Fed huge amounts of breathing room to cut rates Tuesday. Falling oil alleviates inflationary pressure perceptions. Falling gold/commodities supports the notion deflation is around the corner and a rate cut is needed to offset it. Lastly, aggressively cutting rates when the USDX is around 80 gives the dollar a lot of room to fall in response without triggering a currency crisis.

I would also like to point out that we have seen this month that shorts in gold and oil have had absolutely no fear. Both have and continued to fall with two large hurricanes striking key Gulf of Mexico production and refining areas. Shorts continue to pile on as if they have sure a bet irregardless of fundamentals. For example, on August 29th when gold was $835 open interest was 382,329. As of close of business September 10th, open interest was 378,084 for a net reduction of 4,245 contracts after gold fell $73 to $762. A huge price fall of this magnitude would cause open interest to decline 30,000 or more contracts due to long liquidation. This means the precipitous fall in the gold price has occurred with concerted shorting all the way down.

In conclusion, I think the Federal Reserve will surprise the market by cutting interest rates Tuesday. I’ve listed five market observations that taken together make a case for an interest rate cut. This particular Fed moves in time of duress have been to cut 0.75%, which we have seen on two occasions. I don’t think a quarter point would do much to help banks increase their spreads or their stock prices. My belief is that the Fed will cut either 0.50 or 0.75% on Tuesday. I give it a 10% chance that they go the Full Monty and cut a full 1%.

Oddly enough, if the Fed does cut I bet you they’ll say that the rapid fall in commodity prices signaled a deflationary environment and that the rate cut was in part intended to fight deflation. Also, they may use the excuse that Hurricane Ike may have done terrible damage causing economic growth prospects to contract going into their decision at the time.

Toby Hansen