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Market Awaits More Fed Rate Cuts

Nat Worden

The Federal Reserve is expected to announce more cuts to its key interest rate target Tuesday, one day after the central bank managed to stabilize the stock market as investors struggled to comprehend the stunning collapse of a major Wall Street investment bank.

The Fed, with the help of JPMorgan Chase(JPM - Cramer's Take - Stockpickr), helped Bear Stearns (BSC - Cramer's Take - Stockpickr) avoid bankruptcy over the weekend and helped inject liquidity to seized credit markets by allowing investment banks to borrow direct funds in a historic break with nearly a century of policy.

Now, investors are betting that the Fed will slash its federal funds rate target by a full percentage point, from 3% to 2%. Having already slashed 225 basis points from the target since the credit crisis emerged last summer, some observers are wondering if it can ever restore confidence to financial markets with monetary policy, but Wall Street is clamoring for the Fed to try.

"This is like treating a patient that has a gunshot wound," says Ethan Harris, senior economist with Lehman Brothers, "You have to go all out to save the patient. Whether or not the patient could survive without the Fed, I'm not sure."

The Fed's aggressive tactics in aiding Wall Street during this crisis face withering scrutiny from critics who see its willingness to bail out Bear Stearns and other investors as a move that will distort incentives by tinkering with the free markets.

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"It is remarkable to see a group of individuals who claim to be believers and advocates of free markets cower at the mere thought of markets setting their own course," said Mike O'Rourke, chief market strategist with BTIG-Bass Trading. "The conversation should not be centered around the fear of disappointing the markets, it should be centered around the fear of the market itself. Fear of the market is healthy. It's what keeps investors from leveraging 32 to 1."

Treasury Secretary Henry Paulson said at a press conference Monday that the "moral hazard" implications of the Fed's bailout for Bear Stearns, which helped it avoid bankruptcy, were mitigated by the colossal losses suffered by the investment bank's shareholders over the last week.

"Our priority is to provide stability for our financial markets," said Paulson.

The rate odds for a 100-basis point cut spiked from just 52% on Friday, after Bear Stearns -- trading at close to $80 a share at the beginning of this month -- was acquired in a fire sale for a stunning $2 a share by JPMorgan, with $30 billion in emergency funds provided by the Fed.

Despite all that cash, Bear Stearns cost a measly $260.5 million. Now, rumors are spreading that other investment banks -- like Lehman Brothers(LEH - Cramer's Take - Stockpickr) -- are experiencing liquidity problems. Investment banks and other financial institutions are loaded with mortgage-backed securities whose value are a mystery amid historic declines in the U.S. housing market and spiking mortgage delinquencies and foreclosures on markets around the country.

Meanwhile, the Fed's critics point to the value of the U.S. dollar, which is plunging against foreign currencies as the central bank pumps fresh liquidity into the financial markets, tempting inflationary pressures.

"Not moving aggressively would be a very risky strategy for the Fed," says Lehman's Harris. "If the financial system collapsed, the dollar would be performing even worse than it is now."

Subodh Kumar, chief investment strategist with Subodh Kumar & Associates, says the Fed wants to get its key rate target down to 2% by June.

"They have to get down to 2% as quickly as possible, so I would not rule out that they do that [Tuesday]," says Kumar.

The central bank has taken a number of drastic measures to extend credit to the banking system in unorthodox ways as the liquidity crisis has intensified in recent weeks. Most recently, it announced it will slash the discount rate and let securities dealers borrow funds from the Fed on similar terms as banks, marking the broadest expansion of the Fed's powers since the Great Depression. The move was the clearest sign yet that the Fed is scrambling to prevent a systemic breakdown in a financial system loaded with illiquid, derivative securities.

"One investment bank failure poses little by way of macroeconomic threat, but a systemic breakdown is a different issue altogether," said Ian Shepherdson, chief U.S. economist with High Frequency Economics, in a note to clients. "It is important to remember here that the financial system is in much worse shape than the macroeconomy."

The offer was effective as of Monday and will last for at least six months. The Fed lowered the rate charged at its discount window by a quarter of a percentage point, to 3.25%, and extended the maximum term to 90 days from 30.

The Fed has slashed 225 basis points from its fed funds rate since the credit crisis began last fall -- with 125 basis points of the move coming in January alone.

Stocks in general held up better on Monday than many expected -- considering the carnage. The Dow Jones Industrial Average rallied to a gain of 0.2%, while the S&P 500 shed 0.9% and the Nasdaq Composite was down 1.6%.

Financials, however, continued to get slaughtered. Citigroup(C - Cramer's Take - Stockpickr) dropped 5.9% to trade at just $18.62. Merrill Lynch (MER - Cramer's Take - Stockpickr) was down 5.4% and Lehman Brothers was off 19.1%.

President Bush applauded the Fed's actions, saying that his administration was "on top of the situation."

"One thing is for certain, we're in challenging times," said Bush after meeting with his senior economic advisers. "But another thing is for certain: We've taken strong, decisive action."

Merrill Lynch economist David Rosenberg said that like its previous efforts, the Fed's actions this week will be unsuccessful in stemming problems in the financial markets.

"As with all the other liquidity measures, [the Fed's latest move] does not deal with or remove the underlying credit issues that plague the financial markets," said Rosenberg.

Know What You Own: JPMorgan operates in the financial services industry, and some of the other stocks in its field include Citigroup (C - Cramer's Take - Stockpickr), Goldman Sachs (GS - Cramer's Take - Stockpickr), Morgan Stanley (MS - Cramer's Take - Stockpickr) and Bank of America (BAC - Cramer's Take - Stockpickr). For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.