My Thoughts on the Next 24 Hours...

These are very interesting times... At this point in time, after passing up some deals which could have saved AIG, I wouldn't be surprised if we saw at least part if not all of AIG being bought at bargain basement prices by one of its major competitors. I think it will be tough for them to find financing any other way, especially after the recent downgrades. However, I haven't been following the industry too carefully, so it would be tough for me to speculate on an appropriate suitor (list could include ING, Allianz, AXA, etc...). Nonetheless, I am rather glad I haven't taken on any new long positions in the sector recently. Something else we should all be paying close attention to is the effect these failures have on the CDS market, this could open up a whole new bag of worms. I recently read an article which stated that PIMCO alone currently guarantees USD760mn of AIG debt.

As for the Fed, I would be surprised, but not shocked, if we saw the Fed move 50bps today, however they will almost certainly switch to an easing bias in the statement and very likely modify and extend some of the current lending schemes (i.e. changes to the discount window and/or TAF, accepting more assets as collateral, possibly even allowing the Fed funds rate to trade well below target over the next couple of weeks, etc...). I don't really believe a rate cut would be the right course of action, liquidity is the issue not price. However, psychologically it may help the market. All in all the Fed's announcement will likely bring some calm to the market, which could easily be undone by an AIG collapse. We will all get a much better idea within the next 24 hours, as it has been reported an AIG deal would need to be completed by Wednesday. Currently, I am staying on the sidelines, but monitoring the situation closely. Finally, I did notice that the financial sector ultrashort ETF is trading nowhere near its July highs, which I found somewhat interesting. I am not very familiar with this fund, so if anyone has some insight on this please feel free to email me.

As an aside, and as I mentioned was a possibility in my previous post, China has begun easing monetary policy. This could be an important factor once the market does start recovering. Many of China's issues were self-inflicted and reversing policy could have a big impact as investors (eventually) become a bit less risk adverse.

UltraShort Financials ProShares (AMEX:SKF)

Source: Bloomberg

Fed Cuts 75bp

As we expected the Fed cut the fed funds rate by 75bps, and made an equivalent move in the discount rate. What is interesting is that the Fed had two dissenters to the vote, Governor Plosser from Philly and Governor Fisher from Dallas, both wanted a smaller cut. Plosser is a well known hawk on the FOMC, so this was not surprising. However, this combined with a stronger inflation message, could imply the end of strong rates cuts. Keep in mind, the market responded very favorably to the move, despite at one point having priced in a 100% chance of a 100bp cut (the GS and LEH news did help). This also supports the possibility that we could be near the end end of the rate cuts or at least at a point where we see a significant reduction in its magnitude (ie 25bps). Of course the Fed's future reaction will be very reactionary to market news and data.

Investment Idea: We continue to believe home builders may soon become a good play and should be payed close attention to. We will be looking at the ETF 'ITB'

Inflation, Inflation, Inflation

Inflation, we have been talking about, the market has been talking about it, but has the Fed? In short the answer is yes, but it appears the market may not think so. For the first time since its introduction in 1997, the 5-year TIP traded at a negative yield, implying a significant lack of confidence in the Fed's ability to fight inflation. The market is essentially betting that the Fed has lost sight of inflation and is solely targeting growth. We do not agree with the market's assessment. First off, lets rehash an early blog post titled 'Fed Cuts & Inflation' :

"So long as the Fed considers downside risk to growth exists we can expect that rate cuts will remain on the table as long as Core PCE remains below the 2.7% to 3.0% range, or growth conditions do not deteriorate more significantly."

To be more specific, so long as demand continues to be a drag on growth and inflation remains within a 'comfortable' level, the Fed will cut rates. However, if inflation exceeds the Fed's comfort level (as defined above), then we would likely see a quick reversal of policy, or at least the end to rate cuts. Core PCE for January finished 2.18%y/y vs 2.23%y/y the month prior. The Fed has not forgotten their dual mandate. The Fed realizes inflation is trending up, and it is clear that in addition to rate cuts they are looking for alternative methods to alleviate the credit crisis.

With this in mind, to us today's Fed announcement implies a smaller rate cut at their official meeting on March 18^th. We were originally calling for a rate cut of 75bp, but this move, pending how the market reacts over the coming days, changes our forecast to 50bp (with 25bp being a possibility). Of course the relationship between further easing and inflation wasn't the only topic on the Fed's mind in making this decision, but it was probably a factor. The bottom line is the Fed is well aware of inflation and will act accordingly. Markets can only trade irrationally for a finite period of time.

Now What? The Week Ahead

Last week’s performance was pretty much in-line with our expectations, as outlined in our March 2^nd post. But what’s going to happen this week? The beginning of this week is going to be relatively quiet on the data front. However, we will be ending the week with some important consumer related data including CPI, Retail Sales, and Consumer Sentiment (See calendar below).

Nevertheless, the main question this week will be whether or not the Fed cuts rates before the March 18^th meeting and if so by how much. First the easier question, we anticipate the cut will be 75bp. Now the harder one, we think that we are close enough to the March 18^th meeting for the Fed to wait. However, this will be very market dependent. If the market experiences a significant sell-off, then we are likely to see the Fed to act early. Typically, when the Fed delivers unexpected news (such as a rate cut) it usually occurs between 8:15AM and 8:30AM, so please be on the lookout if this scenario does plays out.

If you believe, like us, the Fed would intervene to stem any significant sell-off, then this week could turn into a good buying opportunity. Essentially, the potential Fed rate cut would work as a partial hedge against market risk, not a bad deal. The Fed has a tendency of not disappointing market expectations, and this will not change in the short-term, especially now. So if the market does experience a significant sell-off we would expect the Fed to act (as they did on Jan. 22^nd) and potentially generate at least a short-term rally (See chart below for SP500 performance during the Jan. 22^nd cut). At the same time, if the market does not experience a sell-off, the increased likelihood of a 75bp cut at the next Fed meeting should help bolster market performance.

S&P500 performance during Jan. 22nd inter-meeting rate cut

Market performance will remain very dependent on news from the financial industry and economic data releases. Here are the economic releases that could affect the market this week:

Monday March 10th:
None

Tuesday March 11th:
8:30AM: International Trade (Risk: Neutral)- According to Bloomberg.com the market is currently expecting a trade deficit of USD59.5bn vs. USD58.8bn last month.

Wednesday March 12th:
None

Thursday March 13th: Key Day in a Quiet Week
8:30AM: Retail Sales (Risk: Slight Upside)- According to the consensus survey Retail sales are expected to increase 0.2% M/M for both the headline and core reading. There could be some upside to this release from better than expected sales figures for discount retailers such as Wal-Mart

8:30AM: Import Prices (Risk: Slight Downside)- Bloomberg.com currently states a market consensus of +0.6% M/M change in import prices. Increased commodity and food prices will continue to put pressure on import prices. The big concern is how strong the pass-through effect will be to the overall CPI.

8:30AM: Jobless Claims (Risk: Downside)- Bloomberg.com currently states the market is expecting a reading of 358K. We find this to be one of the most important indicators for the health of labor market. Given continues weakness in the labor market, and signs that the commercial construction industry may be on the verge of slowing; we believe this number has the potential to surprise to the upside. Basically, any reading below 350K is considered relatively healthy, and above could warn of a recession. The 4wk moving average currently stands at 359,500. Non-farm payrolls tend to be a lagging indicator of overall economic health, while jobless claims tend to be a leading indicator, hence its importance.

10:00AM: January’s Business Inventories (Risk: Neutral)- The consensus survey expects business inventories to increase 0.5% M/M.

Friday March 14th:
8:30AM: Consumer Price Index (Risk: Neutral/Slight Downside)- The consensus survey is expecting a 0.3% and 0.2% M/M increase in CPI and Core CPI, respectively. Growing food prices, high commodity prices, and a weak dollar will continue putting upward pressure on CPI. However, how much of this will be nullified by decreased demand is yet to be seen. For more on the importance of inflation and Fed Cuts please see our Feb. 27^th posting (http://fiateconomics.blogspot.com/2008/02/fed-cuts-inflation.html).

10:00AM: Consumer Sentiment (Risk: Downside)- The market is currently expecting a reading of 69.5 after experiencing a free fall last month to 69.6. Given last month’s drop it is hard to make an accurate measurement, but we believe it is likely to come in below current expectations.

*Investment Idea:

We believe the fact that the Fed has always delivered news of inter-meeting rate changes to the market at around 8:15AM EST can be used to our advantage. Take this for example, if the market experiences a significant sell-off and an inter-meeting cut seems likely, you could purchase futures on U.S. Indices just prior to the 8:15AM EST expected announcement. If the cut does occur, then we should see a rally in future prices, and the position could be unwound within 15 minutes. If a rate cut does not occur, the position could be sold within a very short time frame helping to minimize any losses. Since you are only holding the position for a short period of time downside risk should be relatively mild, while potential upside if the cut does occur could be significant. However, you could face other risks such as negative company or sector news being released while you are holding the position. This notwithstanding, if this scenario comes about we believe the risk is worth the potential short-term gain.

*There is substantial risk in trading futures, so please make sure you know what you are doing! Also, this is an investment idea not advice so trade at your risk.