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Never Mind the Bears -- The Fed Cut is Just Right

September 19, 2007

Sept. 19, 2007

NEVER MIND THE BEARS: FED CUT IS JUST RIGHT

"You can't always get what you want. But if you try sometimes you just might find that you get what you need." -- The Rolling Stones

Dear Fellow Options Trader,

As we raced into this week's Federal Open Markets Committee (FOMC) meeting, it was clear that there was a lot riding on the decision from the Fed. But clearer still was the fact that the FOMC meeting was just one piece of a very elaborate puzzle.

The half-point reduction in the Fed Funds rate was a long time coming, and it would be an insult to the Fed governors to claim that any attempt at secrecy about the cut had been made.

The trading in the Fed Funds futures at the CME Group (formerly the Chicago Mercantile Exchange Holdings) indicated for weeks that there was a 100% chance of a cut in interest rates. The only remaining questions were whether the cut would be 25 or 50 basis points and what the wording of the minutes would indicate about the likelihood of future cuts.

Everything else was already set.

It was clear the markets wanted a 50-basis-point reduction in the Fed Funds rate, and anything less would likely be met negatively. CNBC's Jim Cramer was the first to go apoplectic about how bad things were getting and how desperate the situation was, in his opinion, but he was hardly the only one pounding the table for significant interest-rate cuts.

Michael Jackson, CEO of AutoNation (AN), similarly appeared on television to make his case for a 200-basis-point cut in Fed Funds rate. (That's a full two points!) I'll take some mild liberties and paraphrase Mr. Jackson, who said, "We need to get the rate down to 3.25% in a hurry, or the consumer will drive us into a recession!"

Jim Cramer was more entertaining than Mr. Jackson, but the message from both was clear: If the Fed didn't act fast and cut rates substantially, the market's record-breaking run would have officially been over, and thousands of Americans would be finding themselves out of work. Not a pretty picture.

But Cramer and Jackson were not just talking about what the market needed; they were talking about what the market wanted. And those are two entirely different things.

Additionally, they were both talking about their respective situations, one as the trader of his charitable trust and the other as CEO of a business that depends on consumers carrying on with major purchases, undeterred by a negative economic outlook. So, while I respect the motives of both, I believed they were addressing what they wanted, not what they (or other market participants) needed.

In the end, the FOMC and Ben Bernanke did what virtually no one expected them to do -- they cut the Fed Funds and the discount rates by 50 basis points each!

The twin 50-basis-point reductions do more than just cut the lending rate that banks charge each other for overnight money. They also signaled the first easing since the 17 consecutive rate increases began when the Fed Funds rate sat at historic lows of 1%.

BEARING DOWN ON THE BEARS

The fact that we finally got the FOMC off its path of raising rates to stave off inflation was a very significant event. The bears could smell something burning -- and it was them!

The Dow Jones Industrial Average (DJI) rallied 175 points in three minutes, ripping through every offer like Tom Brady through the Chargers. (The Patriots won 38-14 and Brady went 25-for-31 for 279 yards and three touchdowns. What can I say -- I live for football season!)

The wounded bears cried foul and if you listen closely, you can still hear the growling.

They claim the cuts could release more inflationary pressures, and I might agree, as the move -- if not countered by reductions from the European Central Bank (ECB), Bank of England (BOE) and other banking centers around the world -- could result in an accelerated hammering of the U.S. dollar.

This would likely continue to fuel, if you will pardon the pun, the run in crude oil, which trades in U.S. dollars. The thinking here is that each penny that the dollar weakens means more upward pressure on crude oil prices. If crude rallies, then Joe and Jane Consumer cut back on shopping, airlines get hammered, businesses hunker down and we're in trouble with a capital "T"!

There are two factors that the bears can overlook, though, that have held inflation at bay. They are the "incredible shrinking crack spread" and the blowup on Northern Rock Bank in Great Britain.

Let me elaborate.

A CRACK IN THE ROCK

The "crack spread" refers to the verb describing the process of separating and transforming the various chemical components of crude. Crack is therefore the margin that refineries make by cracking a barrel of oil into refined products.

This spread has been crushed in the past six months. Crude is up $20 per barrel and the wholesale price of gasoline, or RBOB, is down.







That's right, you doubting bears -- DOWN from more than $2.40 in April when crude oil was t$67 per barrel. In plain English, the price of gasoline is now $2.07 with crude oil trading at $82!




IT'S NOT EASY BEING GREENSPAN

The unlikely savior was former Fed Chairman Alan Greenspan, who spoke on "60 Minutes," "The Today Show" and on CNBC this week about the housing bubble. As the maestro himself said, the FOMC saw the housing bubble and tried to address it with multiple (17) quarter-point interest-rate increases. However, foreign lenders came into our markets so aggressively that, despite the 425-basis-point increases the Fed threw at us, mortgage rates stayed at historically low levels.

Mr. Greenspan admitted that the Fed did not have the power to force mortgage rates up, because global competition conspired to keep them low, thus leading to the rapid expansion of that worsening housing bubble.

Flash forward to last Friday's headlines of the blowup of the U.K.'s fifth-largest mortgage, Northern Rock Bank. The Bank of England was forced to guarantee deposits to slow the run on the bank, as shares tumbled 25% Friday and another 30% on Monday.

The bailout by the BOE helped shares to stabilize, but it also indicated that the BOE and ECB are now, due to issues like Northern Rock, far more likely to follow our FOMC's lead and cut rates than stick to their previous path of increasing them.

Now here's a little advice to any bears still prowling and growling: Don't fight the Fed! And my advice to you: Enjoy the hype, but stay on your toes. The Fed actions are being well-received by the markets so far, because lower interest rates are typically good for (climbing) stock prices. But that the cut was more-dramatic than many expected, it could indicate that the Fed is doing what it can to head off deeper potential problems.

Traditional buy-and-hold investors want the markets to go up, because they can benefit tremendously from 335-point spikes in the Dow like we saw yesterday. But as options traders, we don't have to "hope" for the best -- we can enjoy the current bullish run, but we can also buy some put options on particular equities or even on the indexes themselves, in case the rally runs out of steam or the next negative headline gives the bearish camp a temporary boost.

But for my money, I think Goldilocks is being nursed back to health with a serving of porridge courtesy of Chef Ben that's "just right"!


Jon "Doctor J" Najarian
Editor
ChangeWave Options Trader