Do Rate Cuts Really Matter?

I find it very interesting that Wall Street has soared the last two days on hopes of more Fed rate cuts. On one hand, this makes sense, but on another, it baffles me.

First of all, stocks do better historically when rates are falling. It’s a mathematical relationship; lower interest rates increase the present value of future cash flows and vice versa. Lower rates also make stocks more attractive relative to other income-related asset classes. That’s the general concept propelling stocks higher this week, but what about the specific situation we face today?

The current dislocation in the credit markets has really hurt the market lately. We all know the state of the housing, mortgage, and mortgage-backed securities markets, but a general lack of liquidity in many other areas of credit are really having a negative impact on the ability of many companies to conduct normal business lines that require liquidity to fund operations.

Will more Fed rate cuts help this part of the problem? The market’s move in the last two days signals that it will, but I am skeptical. My thought process isn’t very complex. The liquidity crisis has gotten meaningfully worse since the Fed started cutting rates (there have been 75 basis points of cuts so far). To me, that indicates that another rate cut on December 11th (even 50 more basis points) won’t have as much of a positive impact on the credit markets as recent stock market action would have you believe.

What do you think?

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3 Thoughts on “Do Rate Cuts Really Matter?

  1. I agree. we were heading in the right direction to resolve and clear a lot of the excesses in the financial system. Also banks started to fix their balance sheets and price risk correctly.

    Now the fed will cut rates and will do so again and again to patch things up, allowing banks and the financial system to keep doing what they used to do: accept a lot of risk for little compensation.

  2. Anonymous on December 1, 2007 at 1:30 AM said:

    I think the main issue is fixing the underwriting model.

    I think the insurance industry has it right on this count. Insurance Brokers are rewarded for writing profitable accounts on behalf of insurance companies. Brokers that don’t produce profitable accounts are terminated. The interests of the policyholder(insured), the broker and the insurer are aligned & risks are properly priced.

    Under the banking model until now mortgage brokers have not been given the right incentives.

  3. John Christy on December 4, 2007 at 6:06 PM said:

    I think this is a case of the market not yet accepting and accounting for reality. I understand the reasoning behind the market’s movement upward with the rate cuts, but I think the market may be having a problem seeing the issues that firms are facing with credit.

    I’d look for a downshift once firms start realizing and announcing their situations as far as having neutered cash positions and disappointing earnings. It may just take a while for the idea to really catch on in the market’s collective unconscious, or whatever you want to term the atmosphere.

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