There is a big misunderstanding on the markets that Federal reserve can save the markets, prevent recession and bail out the faulting homeowners. Though I can’t deny enormous power that Fed possess during good times I see very little choice for them when good times are over.

The market is pricing a 100% chance of 25bp Fed cut by August. I agree that this will happen. But if anyone expects some dramatic cuts, like 0.5% by May, I’m here to warn you that this can’t happen unless Bernanke got brain damage.

1. Cutting rates now will increase long-term treasury yield

Many people think that when Feds cut the 10-year treasury rates go down. Nothing can be more wrong. Long-term rates reflect the trust in dollar to preserve its value over time having low inflation. Any sign of dowish Feds not willing to fight inflation in desire to prevent inevitable recession will destroy the trust in dollar and send the rates up. That will also increase the cost of mortgages, not something we need to face now

2. Cutting rates now will hurt the dollar and raise inflation

The fragile balance of huge outstanding carry trade positions is standing on trust in dollar stability. The rate cut during inflation above comfort zone will trigger the unwinding of carry trade. The sharp decline of the dollar will send import prices up, making everything more expensive, thus increasing inflation. I understand the Mish’ claim that inflation is a monetary phenomena, but jumping import prices do have the direct effect on what we measure, i.e. the basket of prices

3. Cutting rates now will crush the stock market

The enormous $800-billion current account deficit of United States is one of the major sources of performance of all domestic markets, including stocks and real estate. Crushing the dollar with rate cuts will reduce the desire of foreign investors to bring more money in. We will have to live for what we earn, which we didn’t do for a decade. Declining current account deficit will crush the markets

Advertisements