Rate Cut Recap

September 18th came and Wall Street got exactly what they had wanted. As promised by Blistering Bernanke, the Fed "acted as needed to limit the economic fall out from credit mess". Even before a week had passed after the FMOC had slashed the overnight rates, Alan Greenspan was quoted as predicting that home prices will drop further and hurt consumer spending despite the rate cut.

Source- Running With The Bulls

As expected, the stock markets reacted euphorically to the rate cut with all the major equity indices closing positive for the week. Now that the Fed has started easing the overnight lending rate, are the summer doldrums and credit crunch behind us ?

While the rate cut may have improved the economic outlook and brought some relief in the debt markets, it's important that we look deeper into the current mess. The housing market.

Between January to August this year, $263 billion adjustable rate mortgages reset resulting in increased payments for home owners. The number of defaulters and subsequent foreclosures sky rocketed bringing the credit market to its knees. In turn, housing prices tumbled due to inventory build-up and the troubled owners couldn't refinance as banks shut their doors. This is just the tip of the ice-berg. It is estimated that between September and December $700 billion worth of ARMs will reset bringing more pain and misery to the housing market.

S&P/Case-Schiller Home Price Index

The declining home prices and the 67.3% home ownership rates means that the effects of the housing bubble will not only be felt by sub-prime borrowers only but also a significant proportion of households who in turn are expected to cut back on home equity withdrawals. In addition, the tightening credit standards and the decreasing wealth effect brought about by the housing and stock market declines will have an added impact on consumer spending. All these factors will affect the lifeline of the US economy which is built on consumerism.

The fact that the world economy is booming doesn't mean much for US exports which in 2006 came in at $1,467 billion compared to the personal consumption expenditures which accounted for the $9,225 billion out of the $13,195 billion Gross Domestic Product in the US. In turn, the weakening dollar and rising inflation levels in China may have a deleterious effect on the already over-burdened consumers as the US relies on cheap imports to keep consumer prices low.

All these put together doesn't auger well for the overall US stock markets. Even though the rate cuts may bring some relief to heavily indebted households, it is very likely that we will the rate cuts will not bring immediate relief in the housing market.

That said, it will be interesting to see the course taken by the stock market in the next 12 months. Unlike the previous occasions when the the Fed cut rates, we have a very unique situation this time. My guesstimate is that like after the 2001 Tech bubble, things may hold for a while before the Bears have their way as the genesis of the current crisis is the real estate bubble. The fact that Goldman Sachs, which beat estimates last week when they reported, went short on the mortgage industry speaks volume regarding the direction of the market.