This blog post originally appeared on RealMoney Silver on Aug. 20 at 9:11 a.m. EDT.

On Friday night, I appeared on CNBC's "Fast Money" and was asked a critical question: Why fight the Fed in maintaining a cautious market view? After all, the markets soared after the Fed eased in response to the Long Term Capital Management (LTCM) bailout in 1998.

I'll answer that question now.

Back in 1990-1992 and 2001-2003, the Fed lowered interest rates 100 basis points, secure in the belief that it had thwarted a recession. Both times, the Fed was wrong: A recession commenced, and a bear market in equities followed. For example, the DJIA soared nearly 3% with the surprise January 2001 interest rate cut. Three months later, the markets made new lows and ultimately fell 20% from the highs.

Seven years ago, the economy was soaring with real gains of about 4%, productivity was unprecedented, technology was in the midst of a renaissance, and the consumer was in fine shape. The LTCM issue was fairly contained; it was an isolated liquidity crisis in a hedge fund that was forced by the misuse of leverage and the insolvency of a relatively small economy, Russia.

The result was a 75-basis-point reduction in the fed funds rates, which restored calm in the financial markets in a matter of weeks.

Things are far different today.

Today, we face an economy that has far less promise with participants (consumers, hedge funds and borrowers of all kinds and shapes) all hocked up. Unlike 1998, today's housing market is in a sustained downturn, which will not likely recover until 2010. The consumer is at a tipping point, hedge funds don't hedge, and the world's economy faces a broad credit crunch. What was a liquidity issue seven years ago is both a liquidity and solvency issue today.

I have argued that, in the current credit cycle, nontraditional lenders have proliferated by circumventing Regulation T and banking reserve requirements, serving to soften or even dull the Fed's role in monetary policy. In turn, this systemic change has led to unusual borrowing in the form of interest-only and teaser adjustable-rate mortgage loans and levered quant hedge funds.

Furthermore, growth in the derivative market ran amok, serving to underwrite the sale of a broad-based group of products (such as motorcycles, automobiles, furniture, etc.) and also serving to brighten the markets for private equity .

This added liquidity from nontraditional lenders also buoyed the credit market, allowing companies that should have failed to tap large sums of equity and bonds. This created the feeling that all was well with the business world as stock markets rallied around the globe and corporate default rates hit all-time lows in 2006.

But this was an illusion.

With credit being extended to everyone, the consumer -- already having ponied up to the Credit Bar Saloon -- went further into hock by loading up on ARMs and "no-money-down" durable (and nondurable) purchases. The hedge funds, in this period of mispricing of risk, got into the act by levering up in order to capture unsustainable returns. (According to Merrill Lynch ( MER), hedge fund assets now approach $10 trillion, which is supported by less than $1.5 trillion of equity.)

The "hot money" provided by nontraditional lenders eventually led to what we have today and what I have described as a tightly wound financial system vulnerable to any interruption or negative event. The subprime mess was the event that triggered a chain reaction and a reassessment and repricing of risk; it was a ticking credit time bomb that most ignored -- until recently.

Pushing on a String

Pushing on a string means that the positive impact of lower interest rates is overwhelmed by the reduction in credit availability and the desire to borrow, as lenders try to improve the quality of their loan book and repair their balance sheets.

The 50-basis-point reduction in the discount rate will likely be followed by further easing by the Fed, but it will do little good

The combination of stressed and stretched individual mortgage holders, a consumer levered far greater than in 1998, crippled nontraditional lenders, grossly extended hedge funds and debt-heavy subprime companies will exacerbate the downturn in the domestic economy in a far more severe manner than during the LTCM crisis. The two periods, quite frankly, are not even comparable in terms of how secure or shaky the economic foundation is.

Regardless of the Fed's actions, the odds favoring a 2008 recession have been increasing daily and until recently have been almost entirely ignored.

Political Consequences

After the LTCM mess in 1998, the Republican Congress was firmly in control and so was the security of lower taxes for both individuals and corporations. This is not the case in 2007, as the rising odds of a recession and the possible perception that the Fed is working as an agent for corporate America to bail out the hedge funds and troubled lenders already follows the Democratic midterm election victories of 2006.

Also, the growing schism between the haves and the have-nots in 2007 over 1998 will likely serve to give the Democrats the 2008 presidential election on a silver platter -- and with it, the headwinds of rising trade protectionism and higher taxes.

"Don't fight the Fed," a phrase promulgated by Marty Zweig, is one of those nonrigorous "truisms" that may no longer be useful. The markets in August 2007 have had the expected and Pavlovian reaction by immediately soaring; this is just what occurred on Jan. 3, 2001, after another surprise rate cut.

Back then, the Fed and the markets briefly thought that the threat of recession had been eliminated. It had not; we entered a recession soon thereafter. Today, the financial system is far more levered (and stressed) than in 2001, and a reduction in interest rates would simply ease a small portion of the pain of the debt excesses since 2000.

Our investment eyes need to be washed by tears once in a while so that we can see the markets and economy with a clearer view again. From my perch, we are in one such period. Everybody is going to hurt.

Fight the Fed.
At time of publication, Kass held no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $6 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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