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Fed on Hold, Liquidity Is Not

Traders are starting to mull a rate cut, but conditions suggest another hike is more appropriate.

Updated from Sept. 19


Federal Reserve

is widely expected to stand pat at the conclusion of its policy meeting Wednesday, but the markets have taken the next step, pricing in odds of a rate cut in the not-so-distant future.

In the wake of Tuesday's tame producer price index report and weak housing-starts data, the fed funds futures raised the odds of a first-quarter rate cut to 25% from 2%. The Treasury market, which had another big rally Tuesday amid geopolitical unrest in Thailand and Hungary, is clearly betting on a lower fed funds rate.

But while inflation and inflation expectations are diminishing and the economy clearly slowing, there is still little evidence the Fed's two-year tightening campaign did much to stem the huge tide of liquidity in effect since 2002.

Small risk premiums on high-yield and emerging-market debt, low volatility in the market, high investment-grade corporate bond issuance and the sloshing pools of private equity money ready to go to work --

Freescale Semiconductor


being the most recent beneficiary -- are just some of the evidence of still-plentiful liquidity, says Scott Frew, general partner at Rockingham Capital Partners.

Similarly, the stock market's rally from its summer lows has been led by higher-beta stocks, such as



and big-cap tech names, such as


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Clearly, the monetary base has shrunk due to the Fed's 17 rate hikes. The 13-week moving average of MZM money-supply growth, the broadest measure of money supply, has fallen to less than 3% currently from over 10% when the Fed started tightening in June 2004, according to Hays Advisory Group.

Nonetheless, money is very available to anyone or any business that needs some. In the corporate credit markets, where risk premiums are low, access to capital remains robust. The proliferation of the leveraged loan market and the speedy advance of credit derivative markets -- where investors can buy protection against defaults -- has kept bankruptcies to a minimum and lending less risky. Despite the Fed's tightening, investors can virtually lend with immunity, and borrowers can obtain cash with impunity.

"There has been some diminishment of excess liquidity," says Michael Darda, chief economist at MKM Partners. But the effects of excessively accommodative monetary policy after the Internet-bubble burst have not filtered out of the system completely.

To wit, the number of newly rated bank credit facilities of U.S. speculative-grade (read: high-yield) companies grew by 86% year-over-year in the two months ended Aug. 31, according to Moody's Investors Service. These facilities grew by 56% through the first eight months of 2006.

Also, Moody's speculative-grade default rate fell to 1.6% in August from 1.7% in July. Moody's noted the default rate has remained in a narrow range over the past 16 months, never topping 2.1% or falling below 1.6%.

Such loose lending standards are hardly the picture of tight liquidity.

"Credit creation away from the traditional banking system is running rampant," Richard Bernstein, chief investment strategist at Merrill Lynch, wrote in July after the Fed delivered its 17th rate hike. Bernstein argues that given the development of such risk-management techniques and derivatives markets, the lags associated with monetary policy may be longer than usual, and the Fed may have to tighten more than expected. "It should be no surprise that the Fed has not yet severely impacted the U.S. economy," he writes.

While August has revealed some evidence the Fed's rate hikes have had an impact on the economy, their effect could not be called severe by any stretch.

On Tuesday, the Census Bureau reported a weaker-than-expected 1.65 million housing starts in August -- a 6% decline, and the third monthly decline, marking a 19.8% year-over-year drop. August showed the steepest year-to-year drop since March 1995. Economists had expected 1.75 million new homes started in August.

Meanwhile, the Labor Department reported that the producer price index rose 0.1% in August, while core PPI fell 0.4%. This puts year-over-year PPI at 3.7%, with core PPI at 0.9%.

Falling commodities prices and the stabilizing dollar show that things are moving in the right direction. But a rate cut could just "bring back the inflation threat and reinitiate an upturn in inflation expectations all over again, meaning the Fed would have more work to do," says Darda.

Indeed, the Fed's "close call" to keep rates steady at 5.25% in August is a reminder that the central bank is likely to retain its so-called tightening bias, while acknowledging the inflation threat has moderated.

Of course, the market will have to wait for the FOMC minutes, but Richmond Fed President Jeffrey Lacker's dissent last month remains a thorn in the Fed's side. Next month, notoriously hawkish St. Louis Fed President William Poole becomes a voting member of the FOMC, which could introduce even more dissent, formal or informal, says James Bianco of Bianco Research.

For now, Goldilocks was revealed as merely a Princess Leah-like hologram -- maybe she's real, but she's untouchable, or at least in a galaxy far, far away.

Stocks slipped Tuesday ahead of the Fed meeting, as a warning from



injected some anxiety into trading. But the major averages staged a strong reversal in the last hour of trading.

After dropping as low as 11,480.56 intraday, the

Dow Jones Industrial Average

finished down 0.12% to 11,540.91. The

S&P 500

fell 0.22% to close at 1318.31 vs. its intraday low of 1312.17, while the

Nasdaq Composite

fell 0.60% to close at 2222.37 after declining to 2202.93 intraday.

The price of the 10-year Treasury jumped 18/32, its yield falling to 4.73%.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


to send her an email.