Friday, August 10, 2007

Here’s the situation. The subprime problem centered a few months ago on lenders deciding to tighten standards on risky borrowers. No big deal. That was prudent risk management. However, many banks began to fear that the subprime losses at many institutions were bigger than they could assess. As a result, some banks stopped lending overnight to each other. Overnight lending amongst banks is necessary at times to maintain cash minimums mandated by their central banks.

When enough banks were reluctant to lend to each other, overnight lending rates skyrocketed, as the lenders were demanding more interest for the unknown subprime losses. The central banks in many parts of the world feared that the tightening of credit could escalate quite rapidly. After all, if banks are reluctant to lend to each other, chances are few businesses could get loans, too, which would force many businesses to liquidate assets.

For example, if a hedge fund can’t get short-term cash, it will be forced to sell long positions and cover shorts to raise cash. This happened during the past few days, which is why a lot of fundamentally superior stocks led the sell-off yesterday, and a lot of junk stocks actually rallied. In other words, hedge funds were selling their good stocks and covering short positions in their junk stocks to raise cash.

These liquidations and the jump in overnight lending rates caused many central banks to step in and inject hundreds of billions of dollars into the system to bring the overnight lending rates back down to the central banks’ target lending rates. In the U.S., this is the federal funds rate, which is at 5.25%. In Europe, the target rate is at 4.0%.

During the past two days, the European Central Bank (ECB) pumped €155.85 billion ($214.56B) into the system, the U.S. Federal Reserve injected $59 billion, and other central banks around the world added billions, too.

The sudden and massive injection of money into the system caused the overnight lending rates that the banks charge each other to come back down toward their central bank’s target lending rates. Basically, these central banks are attempting to prevent credit fear from turning into a ‘run on the banks’, without having to lower short-term interest rates, as most central banks are still worried about inflation.

In fact, the ECB is in a bit of a quandary. It was expected to raise interest rates by 25 basis points to 4.25% in September. Such a move is looking less likely if the ECB is pumping liquidity in the system.

The Federal Reserve’s Federal Open Market Committee, which adjusts short-term interest rates in the U.S., held rates steady this week, and stated that inflation is still its key concern. Nevertheless, it did acknowledge that the market turmoil at hand is threatening its economic outlook for moderate growth.

And when you consider the actions the Fed took yesterday and today, it is becoming more and more likely that a rate cut will happen before November. This morning, the fed funds futures contract was pricing in almost a 50% chance for a 25 basis point rate cut in September, and 100% chance for a total cut of 50 basis points by December.

One pundit is literally screaming for a rate cut right now (i.e., Jim “Scramer” on CNBC). Donald Trump wants the Fed to cut rates by a full point immediately.

Of course, if the markets calm down soon and become satisfied with the liquidity injections, the Fed will try to keep the federal funds rate at 5.25% longer.

Even if the Fed holds at 5.25% longer, we still think it will cut short-term rates sooner than most as energy costs and the core rate of inflation come down. By the way, the July Producer Price Index comes out next Tuesday, and the July Consumer Price Index gets released on Wednesday.

As oil prices continue to fall, despite tightening inventories, inflationary pressures are continuing to moderate and the Fed will soon have the opportunity to cut key interest rates on its terms. We expect that the Fed will cut key interest rates by 0.25% at its September Federal Open Market Committee (FOMC) meeting as the core rate of inflation falls further within its comfort zone.

CONCLUSION

We had a couple of retests of the lows this week, but we could very easily bounce along these levels for several more days. We could even see lower lows, but we think most of the damage is done. In fact, we think the damage has been excessive, and stock prices will snap back once the fear dissipates.

We’re already seeing some serious institutional bottom fishing. That’s why many of the fundamentally superior small and mid-cap stocks soared today. There were several stocks in this club that were up 10%-20%, and many more up 5%-10%. That’s further confirmation that they were oversold from forced liquidations by hedge funds and portfolio managers.

Get some rest and relaxation this weekend. We’ll be doing a lot of research and keep you posted.

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