More Signs are evident that the 50 Basis Point Rate Cut ...part 1

[Hyperion]

... was not only unnecessary but could result into elevated economic problems in the future – Part 1

Friday’s U.S. employment report for September showed continued strength in the Labor Market at first glance but private sector payrolls continue to be under pressure.

More importantly August’s decline of 4,000 jobs was revised upward to a gain of 89,000. Reports of the initial decline gave the U.S. Fed, under the helm of the incapable Ben Bernanke, the final push to lower interest rates by an aggressive 50 basis points.

The rate-cut came just days after Bernanke at a conference mentioned that it is important to lower global trade balances. This is not the first time Bernanke flip-flopped and gives more reason to replace him as the Fed Chief.

Although the unemployment rate ticked up to 4.7% the U.S. labor market seems to be reasonable well at the moment but early indications of weakness should not be ignored.

Signs of the potential of wage-based inflation were present and the continued increase in hourly earnings, which are at a year-to-date high, should be a factor to watch. Currently it seems that any signs of inflation and inflationary expectations are largely ignored not only by the Fed but by the majority of investors as well.

The U.S. consumer, the backbone of the economy, currently carries a heavy debt-load and, although it should be the Feds goal to provide long-term price stability and combat inflation and inflationary expectations, the rate-cut gives consumer little reason to reduce that debt but rather continue to fuel consumer spending, which is a good thing for the economy if it would not be heavily dependent on debt, and further add to credit problems in the financial markets.

The ongoing housing melt-down which is very likely to last for some quarters and the most recent problems in the credit markets were primarily caused by very low interest rates for an extended period of time. The aggressive rate-cut is likely to elevate the problems but temporarily delayed them into early next year. Most investors cheered the rate-cut and take the traditional fourth-quarter rally as granted amid hopes that the consumer will be stronger then expected during the upcoming holiday-shopping season.

Third-quarter earnings season will officially kick off Tuesday after the bell and may give decent insight to the potential harm of the recent problems to companies but most importantly fourth-quarter guidance should be carefully evaluated. Many companies may meet and beat third-quarter expectations due the drastically lowered expectations but could derail the expected ‘Santa-Claus-Rally’ due to fourth-quarter guidance below expectations.

The primary factor behind healthy consumer spending is the labor market but to most individuals the biggest illusion of wealth is their home as most consider it their biggest asset which is another reason for financial problems on individual balance sheets. Home prices have not yet experienced the depreciation which is likely to take place very soon. Inventories are at record highs and need to be worked-off which will take time and won’t be achieved without strong price-cuts in most areas of the country. The consumer is very likely to show weakness once home-values depreciate.

The labor market overall seems to be in decent shape but there are sectors which are under pressure outside the financial sector and the mortgage sector. The unemployment rate is on a slow increase but currently not a cause for concern. Once home prices deteriorate consumer spending is very likely to feel a direct negative impact which will cause the economy to experience further down-ward pressure and increase the chance for a recession next-year.

The Fed tried to stabilize the housing market with the rate-cut but for the majority of home owners won’t feel any positive impact and the housing problem is likely to increase due to the rate-cut. Traditional mortgages are tied to the 30 – Year Bonds which continue to show upward pressure and are above the Fed Funds Rate.

Home owners which opted for exotic mortgage vehicles such as ARM’s who would be pressured with interest rates at 5.25% will still be pressured by interest rates at 4.75% while traditional mortgages will be penalized by the rate-cut. Over 30% of ARM’s are expected to adjust next year which will increase problems in the housing sector and have an impact on consumer spending.

Sub-Prime Mortgages only represent a small sector of the overall mortgage market but there were early signs that some Prime-Mortgages may be under pressure as well and a rise in car-loan deficiencies is cause of concern as it suggests that the problems will and already have spilled over to other sectors of the credit markets.

Investors should be very careful about cheers which continue to show weakness for the U.S. economy as it will take time for a recovery from those problems which could lead to a phase of stagflation given the current ignorance of the Fed in regards to the longer-term impact of the pre-mature and aggressive rate-cut last month.