Why a Fed Rate Cut May Be No Quick-Fix for Credit Markets

In yesterday's blog post, I discussed how Friday's dismal jobs report sent stocks into a tail-spin to end the week on a sour note. Over the weekend and continuing Yesterday, all I heard was a deluge of financial pundits harping about how the Fed MUST cut benchmark interest rates when they meet one week from today.

But would a quarter-point (or even a half-point) cut in the Fed funds rate really be the cure-all for gridlocked credit markets that everyone seems to believe? Call me skeptical!

There's no doubt a very strong argument to be made for why the Fed can afford to cut interest rates on September 18, officially ending its restrictive policy stance held over since the Greenspan era.

Inflation Seems "Well Contained" Greenlighting a Fed Cut

Recent data indicates that inflation expectations have receded. The yield spread on U.S. Treasury issued inflation protected (TIPS) bonds, has fallen to just over 2% -- which indicates that the current 5.25% fed funds rate is too high.

We've also seen a dramatic decline in yields on all Treasuries across the entire yield-curve, from shorter-term Bills and Notes, to long bonds; benchmark 10-year Treasury yields have tumbled to 4.3%.

So the fed funds rate at 5.25% sticks out like a soar thumb! Even the Fed is having trouble maintaining this high target rate.

A Fed rate cut is probably a forgone conclusion after the weak August payroll numbers last Friday, leaving pundits to debate only the degree of easing that should be forthcoming. But at the same time that government-mandated rates are falling, market-based rates for financial-sector transactions are moving higher.

Market Based Interest Rates Likely to Remain Elevated Despite Fed Move

The London interbank offered rate, or LIBOR, rose to nearly nine-year highs at 6.9% today -- up more than a full percent in just the past week! Such an elevated level in this important lending rate signals a general unwillingness among big banks to extend credit.

The reason for this is simple, LIBOR doesn't reflect a mandated target rate of interest set by a government entity (such as the Fed); instead LIBOR is a market rate of interest set by big banks around the world who submit open market offers to lend money to one another on a short term basis in the normal course of doing business. Recently, this normal business of lending has slowed sharply, as reflected by sky-rocketing LIBOR rates.

Banks, Brokers are Stepping Back from Credit Markets, Reluctant to Lend

Since the credit crunch first made headlines in July, all borrowers are considered "suspect" by lenders, commercial paper markets have seized up, even money market funds are looked at with a much greater degree of suspicion.  Banks can no longer be sure of the underlying credit quality of assets pledged as collateral for loans.

In other words, it's no longer the return ON their money that banks are concerned about, it's the return OF their money.

Naturally, in such an environment, global bankers are demanding higher rates for short-term loans, even as politicians and pundits call for a cut in benchmark rates.

To a certain degree then, the Fed may be pushing on a string next Tuesday even as it slashes its target fed funds rate. To be sure, such a move should improve market psychology, by giving the investment "crowd" what it wants. But even a half-point cut in fed funds may not be enough to re-energize the flow of credit in global capital markets. You see, there's still this troubling matter of the slow-motion housing crash to sort out.

Sub-prime Market Shock Still Far from Over

According to research from the Bank Credit Analyst, "about 60% of sub-prime mortgages carry an adjustable rate, and $650 billion of these toxic loans will reset at a higher interest rate in the next 16 months."

There are more than 6.2 million outstanding sub-prime mortgages, nearly half of which are adjustable rate. Delinquencies on these mortgages rose to almost 15% per cent of all loans last quarter, but estimates call for delinquencies to rise much, much higher in the months ahead.

In fact, the peak in sub-prime resets won't occur until spring 2008, so the credit crunch is liable to get even worse, before it gets better. That's because most adjustable-rate mortgages are indexed to rising LIBOR, rather than a (likely) falling fed funds rate.

And higher rates could lead to even higher than forecast defaults going forward, putting more pressure on home prices, and resulting in more hits to the balance sheets of big banks and brokers, leading to even less credit creation. A vicious cycle that's far from complete.