Markets Betting on More Fed Rate Cuts

by Gary Dorsch, Global Money Trends. September 27, 2007

Nowadays, traders of all stripes are betting on an easier Federal Reserve monetary policy. Signs that the US economy is headed into a recession are mounting, led by sliding home prices, a global credit crunch, and the first loss in employment in four years in August. US retail sales stagnated last month, and the glut of unsold US homes reached 10 selling months, its highest in 18-years.

Historically, the US economy has gone into recession seven times since 1960, and six of the downturns were foreshadowed by an Inverted yield curve, where yields on three-month Treasury bills exceed the yield on ten-year Treasury Notes. Usually, when lenders in the bond market are willing to accept lower interest rates for longer term debt than for shorter term debt, it is a signal that the US economy is about to experience a serious slowdown or even a recession within 12-months.

So far in this decade, the Inverted yield curve has made two appearances, in March through Dec. 2000, at the height of the frenzy for internet and high tech stocks, and as recently as July 2006 through May 2007. Soon after the appearance of the Inverted yield curve in 2000, the Nasdaq and S&P 500 imploded in 2001, and an eight month economic recession arrived in 2002.

Today, there is speculation that the US housing bubble might deflate next, bringing on a recession in 2008, and an easier Fed policy in the second half of this year. At its peak in February 2007, the yield on the three-month T-bill rate was roughly 60 basis points above the benchmark 10-year yield. At that time, many analysts predicted the inversion would at least signal slower economic growth, yet few were convinced it would spell a contraction of gross domestic product for two consecutive quarters, the typical definition of recession.

Why did the Bernanke Fed slash the fed funds rate by a larger than expected half-point on Sept 18th, at a time when inflationary pressures are elevated at dangerously high levels in the global economy? Robert Shiller, a Yale University economist, told a US congressional panel on Sept 19th, "The collapse of US home prices might turn out to be the most severe since the Great Depression. The decline in house prices stand to create future dislocations, like the credit crisis we have just seen."

According to the S&P/Case Shiller national home price index, US home prices in the top-20 metropolitan areas fell 0.4% in July from June, to stand 3.9% lower from a year earlier. The index for the top 10 metropolitan areas fell 0.6% in July for a 4.5% annual decline, the worst rate of decline since July 1991 as the economy was emerging from recession, S&P said. Home builders are under enormous pressure to pare down unsold inventories, and are lowering prices.

Meanwhile, existing US home sales fell 4.3% in August to a 5.5 million-unit annual rate, swelling the inventory of homes and condos for sale to 4.58 million units, to a record supply of 10-months. Former Fed chief "Easy" Al Greenspan said on Sept 16th that he would not be surprised if US home prices fell by double-digits into 2008.

A fall in home prices on that scale would be unprecedented in US history and could tip the world's largest economy into recession. US residential real estate has an aggregate value of about $21 trillion, and is the single biggest source of US household wealth. If home prices fall roughly 15%, it could wipe out $3 trillion of household wealth, and deal a huge blow to consumer spending.

A double-digit decline in US home prices could spark big job losses. Construction employment fell about 15% in both the 1990's and 1980's recessions, and it dropped 18% in the recession of the mid-1970's. In each case, the sector's declines were far steeper than job losses in the overall economy, and the recovery took longer. About 7.6 million American workers are employed by construction companies, so a 15% decline would translate into the loss of 1 million jobs.

With the US 2-year T-Note yield hovering at 3.90%, traders are projecting at least 75 basis points of Fed rate cuts to 4.00% in the months ahead. And according to the chart below, the US$ Index usually tracks the direction of the two-year US T-Note yield. The Fed's decision to devalue the US dollar by unilaterally lowering interest rates carries big risks, since it could evolve from an orderly decline into a speculative rout. Foreign exchange trading has mushroomed by 65% over the past three years to a record $3.2 trillion a day on average, led by hedge funds and foreign investors. The sheer volume of FX trading would make central bank intervention less effective in trying to control a crisis situation.

Gary Dorsch

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Gary Dorsch | Editor and Publisher, Global Money Trends
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