Jason Kelly

I expect volatility around the sub-prime induced credit slowdown to continue for the next few months.

BCA Research monitors the relative performance of bank stocks, the yield curve, credit spreads, consumer confidence, market leverage, private debt, and new bond and equity issuance to come up with a U.S. Financial Stress Index. It moves on a scale from -2 (little stress) to +2 (great stress).

For perspective, the S&L crisis of 1989 pushed the index over +2, the Long-term Capital Management implosion of 1998 sent the index to a little under +1, the dot.com meltdown of 2000 saw the index approach +2, and the current sub-prime fret has the index approaching +2 again.

Lest you think this is cause to skip Christmas and say "Crappy New Year!" at midnight on December 31, just look back at how the stock market has done since those other stressful times.

The S&P 500 has gained 434% since the S&L crisis, 55% since the LTCM implosion, 43% since the middle of the dot.com meltdown, and 82% since the end of the dot.com meltdown. Read market history and you'll note that the ballyhooed "end of the modern financial system" never was. It isn't this time, either.

BCA says the Fed is behind the curve on lowering interest rates to stave off further credit trouble and recession. Joining BCA has been a chorus of analysts attacking the Bernanke Fed.

Conversely, Briefing.com president Dick Green wrote last Monday:

The criticism of the Fed is way overdone.

The Fed started cutting the fed funds rate in September. That was the end of a quarter in which real GDP rose at a 4.9% annual rate. The numbers are adding up to an increase in fourth quarter real GDP as well. If a recession hasn't yet started, that means it comes in the first quarter of 2008 at the earliest. The Fed would therefore have started cutting rates at least four months before the recession started.

The Greenspan Fed, often blamed for having kept rates too high too long ahead of the 2001 recession, left the fed funds rate at 6.5% through the end of 2000. The first rate cut was to 6% on January 3, 2001. By then, the recession had already started as first quarter real GDP posted a decline. The fed funds rate did not get down to the current level of 4.25% until May of 2001, well after the recession had begun.

The Bernanke Fed has thus moved faster than the Greenspan Fed did in 2000-2001, and from a lower fed funds rate target, to get rates down before a recession started.

Regardless of whether the Fed is behind or ahead, it looks likely to lower rates further in the medium term.

The market wants lower rates right now, not in a few months. That impatience will sweat volatility everywhere you look until rates get where the market wants them. They will get there, however.

Too, credit worries will fade as they always have in the past, lower interest rates will stimulate the way they always have in the past, and even the overkicked dead horse known as housing will get back on its feet and remind everybody surrounding it that it never did account for more than 5% of the U.S. economy.

The short term will remain rocky while we wait for the Fed to catch up, but there's hope on its heels.

Posted by Jason Kelly at 9:29 AM Japan time
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