The Losses From the Surprise Federal Reserve Rate Cuts

Today, January 22, 2008, the Fed announced a surprise 0.75% cut in the fed funds rate and the discount rate. This announcement was made in between regularly scheduled Open Market Committee meetings, and was the result of a special teleconference meeting. The Fed's statement explaining the surprise cut (www.federalreserve.gov/newsevents/press/monetary/20080122b.htm) says that the Fed took this action because of a "weakening of the economic outlook and increasing downside risks to growth." However, there is little doubt that the real reason for the rate cut was the sharp drops in Asian and European stock markets the last couple of days (almost 10% in Japan and around 4-6% in Europe).

The U.S. markets gyrated widely today, dropping over 4% and then recovering to close with the Dow down 1% and the Nasdaq down 2%. Did the Fed rate cut help? It probably gave some comfort to stock investors. But the reality of today's financial markets, with derivatives contracts that allow you to bet on any price movement of just about anything that is traded, is that nothing happens without creating losers as well as winners.

Among today's losers would be anyone on the short side of the Treasury securities market or the AAA rated corporate bond market. An interest rate cut would reduce the value of any short position in these securities. Since the Fed's action was a surprise, the risk of such a cut would not have been priced into the original trade in which the short position was taken.

Similarly, anyone holding the fixed rate side of an interest rate swap would have lost money. Interest rate swaps, in essence, involve an exchange of the risk of a fixed rate loan (which would lose value if rates go down) for the risk of a variable rate loan (which would lose value if rates go up). A surprise action by the Fed would probably not have been factored into a decision to participate in an interest rate swap. So the holder of the fixed rate would have taken a loss.

Other losers would have included those silly people who save money in bank accounts and money market funds, in the belief that prudence and restraint will somehow be rewarded. Will these savers help stimulate the economy with greater spending when their interest and dividend income is dropping? That's doubtful. It's another example of how, in today's wonderland financial markets, no good deed will go unpunished.

It is hardly a secret that many market players factor their expectations of the Fed's actions into their trading decisions. Chairman Bernanke has, if anything, fueled this tendency by promising greater transparency of the Fed's intentions. Today's surprise cut, though, may have damaged the Fed's program for greater transparency. The derivatives markets could become more illiquid when there is an increased risk of Fed surprises. With asset-backed derivatives, other structured finance instruments, and credit default swaps already under severe pressure, it wouldn't help to make the market in interest rate risk more illiquid.

The losers could include banks, hedge funds, insurance companies and other institutional investors. Because the derivatives market is largely unregulated and quite opaque, the impact of the losses from today's cuts may not be known until first quarter 2008 financial results are reported in March for many investment banks, and in April for many commercial banks. Hedge fund losses probably wouldn't ever become public, although their impact could be felt in reduced liquidity. The financial markets will see the benefits of the rate cuts immediately; but the losses will be revealed only months later. If those losses are significant, the Fed may have set the stage for more instability.

The dual-sided, anything can be traded derivatives markets make it harder for the Fed and other central banks to take monetary action that would produce a net benefit. The more ambiguous monetary policy becomes, the more illusory it will be. Time will tell soon enough what we are dealing with.

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