Alright Bernanke, Enough with the Rate Cuts

Do you get the feeling that FOMC Chairman Ben Bernanke is lowering interest rates more because that is what the markets want, and less because it is actually helping the problems we have in the housing and credit markets? The debate has long been whether or not the mortgage crisis will be contained or spread into the rest of the economy and cause a recession. With third quarter GDP growth coming in at 3.9%, the highest rate since early 2006, it is clear that the economy is a lot more than just the housing market.

While GDP growth should slow meaningfully in Q4, it does appear the mortgage problems are contained. Unless rate cuts will help stabilize the housing market, which is not a likely result, I don’t see the need to go ahead with them just for the market’s sake. After all, commodities like gold, oil, wheat, corn, etc are soaring. The result will be higher prices for consumers, which we have already begun to see as companies like FedEx, Colgate, and Procter & Gamble are all raising prices to maintain their profit margins and stock prices.

In the face of apparent inflation pressures, interest rates could ultimately be headed higher, which would make the recent cuts even more baffling. It’s true that the government’s inflation data doesn’t seem to jive with reality, and maybe that will reduce the likelihood that rate increases are in our future, but when press release after press release announce price increases from major manufacturers due to record commodity prices, it’s hard to deny inflation is real.

So what will cure the housing market’s woes if rates cuts won’t do the trick? Honestly, just the laws of supply and demand. The housing market is still falling with no signs of stability in sight. As long as delinquency and foreclosure rates continue to rise, and home prices continue to fall, the credit market issues (loan losses and asset backed securities writedowns) will continue. The value of loans won’t stop falling until the performance of such loans improves, or at least stop deteriorating.

Rate cuts won’t help because they have no direct impact on home prices or mortgage delinquency rates. This will be apparent when we see fourth quarter loan performance continue to get worse, not better. As home inventories are worked off and more home owners refinance into fixed rate loans, the markets will eventually stabilize. It will take time though. I don’t know when, nobody does, but hopefully we can get there by the end of 2008.

As for whether the housing market weakness has spread to other areas, this debate obviously will continue. From third quarter earnings season we see that the weakness has really been contained to home builders, mortgage lenders, banks and investment firms that own securities backed by mortgage loans, and companies that provide insurance for mortgages and mortgage backed securities. It is my belief, and many will certainly disagree, that consumer spending is not as bad as some would have you think, and the fact that growth in spending is lackluster has much more to do with the face that real wages have been stagnant for years, and not because of the housing market. In addition, the fact that consumers are staying current on all their other monthly bills, even when they are delinquent on their mortgages, shows that the housing market’s issues really are fairly well contained.

As for policy moves, I think actions should be focused exclusively on stabilizing the housing market. While pleasing to the markets, I don’t see any direct impact on housing from rate cuts. Just imagine how great it would be if we could get back to a “normal” housing market. People would have to get used to not making much money on their homes (real estate returns historically don’t outpace inflation), but the credit markets would stabilize and corporate earnings could resume their growth trend. Even a flat housing market would be welcomed by investors, to say the least.

Full Disclosure: No positions in the companies mentioned

Enjoy this post? Subscribe and never miss another one: RSS | Email | Twitter

6 Thoughts on “Alright Bernanke, Enough with the Rate Cuts

  1. Anonymous on November 2, 2007 at 8:47 AM said:

    Chad, I bought some BAC back on October 19 partly on your blog entry the day before. I didn’t sell the put like you recomended so I don’t know if that was my mistake. I think the put is down though. I’m down almost 10% already and I’m wondering if you think I should hold on here or sell?

  2. Chad Brand on November 2, 2007 at 9:15 AM said:

    Re: BAC

    Just to clarify, the trade idea was to buy BAC (it was around $48), sell the May 2008 calls at $1.75, and collect six months worth of dividends ($1.28). All of this would result in a breakeven point of around $45 per share. The stock today is $44 and change on renewed worries about the health of the banking sector.

    As with every contrarian investment, a long term time horizon is imperative. I have no idea what will happen in the short term, especially in the financial sector where psychology and fear is driving market movements.

    I don’t know you personally, so I can’t speak to what you should do specifically. That said, if you share my belief that this credit crunch will resolve itself at some point, and you are patient and have the time to wait it out, I do like BAC as a contrarian investment. They have less mortgage exposure than JPM and C, and I do think they’ll come out of all this just fine.

    The short term though, is anybody’s guess. My trade idea was based on the fact that I felt good about having a breakeven point of $45 per share in May of 2008. I still feel that way, and still own BAC shares, even though near term volatility is clearly here to stay.

  3. Anonymous on November 2, 2007 at 9:43 AM said:

    I meant to say call. Sorry. I’ll ty to hold on.

    I just dont see anything that will get people excited about banks in the near term but I guess that is why it is trading here now. Thanks.

  4. Chad Brand on November 2, 2007 at 9:49 AM said:

    I agree about the short term, but I’m a long term “investor” not a short term “trader” so I am content with the fact that I have no idea what will happen to the market in the short term.

    As for Cramer, well, hopefully there aren’t too many of my readers who are using his advice to manage their own accounts. Remember, he used to be in the investment advice business but quit to be in the entertainment business.

  5. Anonymous on November 2, 2007 at 9:53 AM said:

    How can you say that you have no idea about what is going to happen in the short term but be so confident that you know what is going to happen in the long term?

  6. Chad Brand on November 2, 2007 at 10:07 AM said:

    Good question.

    In the short term stock prices are dictated by any number of things; psychology, emotion, fear, greed, the media, hedge fund traders, rumors, etc. The fundamentals don’t always matter.

    Over the long term stock prices are dictated by corporate earnings. The fundamentals do matter over time because of what a share of stock actually is, a piece of ownership in a business that entitles the holder to a representative share of the business’s profits.

    To me, one is far easier to predict accurately than the other. Said another way, my “batting average” predicting long term earnings patterns will be much higher than one trying to predict what the market will do today, next week, or next month. It really comes down to the definition of a contrarian value investor and what they are trying to accomplish.

Post Navigation