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Across My Desk: What happened last week?

If you found yourself all worked up and uncertain about what all the recent market hoopla was about, not to worry. Louis Navellier, in his latest e-mail, did a great job of explaining the situation. What follows is the Marketmail received from his company on Friday, August 17, 2007:

"The stock market got a badly needed boost from the Fed today when it lowered the discount rate from 6.25% to 5.75%. The discount rate is the rate that banks are charged to borrow short-term funds directly from the central bank through the discount window.

Banks sometimes need to borrow overnight from other banks or the central bank to maintain the required reserve ratio set by the central bank. The reserve ratio is the minimum reserves a bank must hold to customer deposits and notes. The reserves are set at a level to satisfy withdrawal demands.

The fed funds rate is the rate that banks charge each other for short-term funds. The discount window is typically used by banks during times of distress, when they can't get loans from other banks, hence the higher interest rate than the fed funds rate. The discount rate is now at 5.75%, and the fed funds rate is at 5.25%.

Greg Ip and Brian Blackstone at The Wall Street Journal said, "The Fed's decision to lower the discount rate and ease the terms of discount borrowing but not cut the fed funds target suggests that for now it believes the problems in the markets are mostly related to the availability of cash, not the price of cash."

In other words, by changing only the discount rate, the Fed is trying to do whatever it can to prevent a credit crunch without having to lower the fed funds rate. Some believe this indicates that the Fed will not lower the fed funds rate at its next meeting on September 18, especially if the stock market stabilizes beforehand.

However, a Goldman Sachs' economics research team disagrees. "While this probably has bought them some time, the FOMC has clearly stated its increasing concern about the implications of the market stresses for the economy. In our view, as stated this morning, those concerns will prove to be well founded. Hence, we see this as a signal that they are more willing to move more if needed than previously evident."

Joe Kalish at Ned Davis Research called the discount rate cut a 'slick' move, and said that it was more symbolic than real. Mr. Kalish provided these four reasons:

  1. The Fed wants the market to work out its own problems. It is still cheaper to borrow in the fed funds market than at the discount window. It is standing by as a lender of last resort.

  2. crisis. It remains to be seen whether anyone will take up the Fed's offer.

  3. The underlying credit problems remain.

  4. To lessen the economic fallout, the Fed will still need to cut the funds rate, probably at the next scheduled meeting on September 18. Citing "downside risks to growth have increased appreciably," the FOMC effectively removed its tightening bias. The FOMC continued that "it is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruption in financial markets." But it is not clear whether they have an easing bias, although some may interpret the statement that way.

Some experts believe the Fed decided to cut only the discount rate because the Fed is anticipating that an institutional failure is at hand.

In a note to clients, Carl Weinberg and Ian Shepherdson from High Frequency Economics said the possibly failing institution was "probably not a bank, but rather an institution that has substantial bank liabilities that may not be able to clear."

Whatever the case may be, in the least the Fed appears to be drifting away from its key concern that inflation could fail to moderate, and toward alarm that economic growth could decline more than expected as a result of the credit crunch.


We are not out of the woods yet. In all likelihood, we will have to retest the lows reached yesterday before we will see the stock market rebuild and take out the Dow's 14,000.41 high.

We would not be surprised to see a failure or two ahead, like a lending institution or a big hedge fund. Such an occurrence could put us in retest mode and force the Fed's hand.

The good news is the Fed's discount cut is probably foreshadowing a 25 basis point cut in the fed funds rate on September 18. In fact, the fed-funds futures contract is pricing in a 100% probability for such a cut, and the market believes an additional 25 basis point cut before yearend is in the cards, too. The fed-funds futures contract is incredibly accurate. We can't remember the last time it was wrong. It's been a long time, though.

We firmly believe that a fed-funds rate cut will produce a massive rally. By the way, did you notice the sudden surge yesterday? That largely happened because a rumor that the Fed was going to have an emergency meeting last night started to swirl on the exchange floors. Our traders were getting calls from various desks across the country talking about it.

Obviously, everyone expected the emergency meeting to yield a fed-funds rate cut. Many probably read the headlines this morning and didn't know the rate cut was only the discount rate, but bought stocks anyway. That's why the Dow shot up 320 points at the opening, and then gave back a lot after everyone absorbed what the bottom line really was.

The bottom line is stock prices will surge aggressively if the Fed cuts in September. Here are some historical charts that show how the S&P has performed after the first, second, and third fed-funds rate cuts.

Thank you for reading Marketmail."

And that's one man's opinion.

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