Vad's Best Ideas

"Recession is when your neighbor loses his job. Depression is when you lose yours."
Ronald Reagan

I think that tomorrow's meeting could determine which one of the above we might end up facing here in the United States in the next 12-18 months...It might sound a bit dramatic and many people out there will probably question my judgment for making statements like this but, oh well, I am not running up for reelection which is why I can state what I think and not what other people want to hear. Here is my rationale:

Fed's job to me is composed by two objectives:
1. Primary objective- achieving price stability
2. Secondary objective-helping economy to achieve its full growth potential

Now let's assume we are stepping into Ben's shoes for a few minutes- we are faced with many choices and none of them are perfect:

"Choice 1"- By cutting rates dramatically in the next few months, the secondary objective ("growth") could be fulfilled (at least in the short term). But in this case inflation problem is going to be become a real issue. Commodities will receive additional support from the expectation of rejuvenated growth; speculators are going to bet on further rate cuts which in turn might push existing bubbles (ex. commercial real estate prices) even higher; dollar should lose even more ground which would in turn again increase import prices. Combined all of these and many other issues and we could see significant inflation pressures in the short term, which would eventually again lead to another series of rate hikes, followed by what could become a prolonged period of real stagflation or depression (high inflation-low growth)

"Choice 2"- Fed could cut rates by 25BP max, with a statement that tells everyone that are no more cuts in the "wizards" sleeve for a while, or may be no cuts at all for now. That move would likely lead markets to drop significantly with commodities, financials and emerging markets falling harder than others. Many more bankruptcies in the financial sector would be likely, commodities should slump and thus recession would come faster than in other scenarios but it would also likely not to be as lengthy, because all the current excesses would be shaken off very rapidly. To sum it up - this scenario is likely to achieves the primary objective- inflation will be destroyed but will also reduce short term growth and likely to lead to higher unemployment faster than other scenarios.

"Choice 3" or "2A"- Fed cuts rates by 25BP on Tuesday with some additional "styling" on top of it- may be something like additional cuts in the discount rate or statements in support of increasing caps of Fanny and Freddie. Market should sell off again but not as heavily as in "Choice 2". But inflation expectation should not spike as high as in "Choice 1" and who knows may be even the indication that Fed is taking at least some proactive action will improve liquidity to more acceptable levels, which should support US economy for a few more quarters. However, given all the accumulated excesses in the world's markets- real estate bubbles throughout the world, Chinese high fever/unsustainable growth, yet unexposed bad loan problems etc that are just starting to blow all around the world will still force the economy into recession. Whether this recession will be as lengthy as in "Choice 1" is unclear at this point.

"Choice 4" - Fed believes that the economy can weather all the storms and that strength of the IT and Industrial sectors of the economy and strong exports growth combined with always "trigger happy" free spending consumers will carry the US economy out of any slowdown in growth. In this case no cuts are necessary- while this scenario could be possible I would assign a very low probability of this actually happening- no more than 20% or so...

I am great believer in "invisible hand of the market" that is why I would make a "Choice 2". It is very likely that recession will be here one way or another in the next 12-18 months- the question is-which route will the Fed take? Just think of US economy as a patient with cancerous tumor ("inflation") in one lung that has been treated with chemotherapy ("rate hikes"). Patient's wife ("general public") tells the doctor ("Fed") that based on what her friends and neighbors ("politicians") are telling her- it's not a big deal and this time it will be different. Doctor ("Fed") tells her that the he is not sure that the decease has been completely cured and thus he recommends continuing the treatment ("Holding rates steady") because he needs to monitor the patient a little longer before making judgements whether cancer is gone. Now wife can listen to friends and neighbors (who's expertise in medicine is just great as in monetary policy matters) and risk being back in the hospital within the next few years with a tumor in the second lung, or she could leave doctor alone and let him do his job.

Now if you were faced with this situation would you consciously make a choice of ignoring the doctor's advice and having the cancer come back with potentially lethal consequences or would you ignore the politicians and make your own decision?

P.S. If I had a hundred PhD staffers armed with most recent data points, we could probably quantify a little better what the implications of most likely scenarios could be. But just on the surface while Scenario 3 is probably most likely to occur due to political and market pressures, I would personally go with Scenario 2.

P.S.S. Anyway, enough talk for now- here what I did on Friday to prepare for Tuesday- I took some profits off the table from the expected pre Fed- sub prime rally and bought two sub prime relative underperformers- FMT and DFC both are now at roughly 10% of my portfolio. To hedge the downside I have also entered into positions that I rarely take- ultra short ones- those should offset possible downside volatility -QID, TWM and SNM. I hope principles will win over style on Tuesday but you can never be sure... Better safe than sorry.

Trade safe and cheers,
Vad

Comments: View Comments |  Monday September 17, 2007