Tags: Ben Bernanke, Interest Rates

How to Play Today's FOMC Meeting

By , Money Morning •

By Martin Hutchinson
Director of Global Investing Research

Wall Street has firmly got it into its tiny overpaid noggin that the Fed Chairman Ben S. Bernanke and the central bank's Federal Open Market Committee will slash interest rates today.

I'm not so sure.

Whatever Bernanke & Co. does will indicate the medium-term future of Federal Reserve policy and, more important to investors, will probably guide the future direction of the markets for the next year or so. So it's worth looking at the possibilities, as this single decision will be the guiding light for your investment strategies for the months ahead. Even so, despite what you may be hearing, the results won't be uniformly positive.

The Newest Speculative Mess

The crisis that has caused all the angst is a pretty simple one of a type that has recurred all too often through history. Credit became all too easy to get, meaning it became very easy for a bunch of guys who weren't at all creditworthy to obtain money.

These non-creditworthy guys are most obvious in subprime mortgages, but there have been some overpriced leveraged buyouts done, which have left over $200 billion in potentially wobbly debt on banks' balance sheets. In addition, I can't believe subprime credit-card loans won't soon be in just as much difficulty as subprime mortgages, because of more or less the same irresponsible lending. Finally, some of the more-marginal emerging markets, with too much debt, will descend into trouble if the world economy slows.

If you look back at every speculative crisis throughout history there's always been some sort of new wrinkle that allowed the new generation of financial snake-oil salesman to sell the latest bill of goods to the newest group of soon-to-be shorn sheep.

This time around, the new "financial technology" is an ill-advised mixture of derivatives, asset-backed commercial paper, and securitization. This spread this glut of crummy debt all over the globe faster than SARS on a cut-rate airline…. now nobody knows where it all is. Brilliant! That's why even interbank markets have seized up, with the international benchmark three-month London Interbank Offer Rate (LIBOR) trading far above the benchmark U.S. Federal Funds rate.

Rate Reduction Realities

If that financial history we referred to earlier is any indication, then it must be a law of financial physics that even when a financial innovation is a good thing in general - and figures to be a useful tool - it often seems to spawn an early crisis in which it is overused and creates a huge mess.

It follows that cutting the Federal Funds rate won't do much.

It won't restore confidence in the world's banking system; that will take time, and good auditing, to find where the bodies are buried.

It won't rescue the U.S. housing market: The subprime loans are getting "subber-prime" by the day, and an incremental cut in short-term rates won't help them much.

Indeed, about all this rate cut will do is get Bernanke out of the firing line of angry Wall Streeters who are despairing over their 2007 bonuses, if you call that a good thing. And even there the rate cut will only be partially successful, as many of the folks on 'The Street' are predicting (or is that hoping for) a bigger rate reduction than the one Bernanke and the FOMC will probably order this afternoon.

Besides, the rate reduction is coming at a less-than-strategic moment, and will likely worsen inflation.

How to Play The FOMC Meeting

When you get right down to it, there are really three possibilities for tomorrow's Fed policymaking meeting:

  • First, the Fed could do nothing at all, holding the line on interest rates.
  • Second, the central bank could cut the benchmark Fed Funds rate by a token quarter point, and accompany its announcement with a stern lecture on both speculation and inflation - capping it all off and punctuating its point in stunning fashion by adding a resolution that lets us all know that no more rate relief will be forthcoming [Note: With that stunning addendum, I guess this second possibility officially becomes possibility 2a.].
  • Third, Bernanke gives in to Wall Street completely, slashes interest rates by half a point or even more, vows to bail out the debt market no matter what it takes, and sends both Larry Kudlow and Jim Cramer out on the town for a splurging celebration [perhaps having a bit of fun by charging the night's food and festivities on a subprime credit card].

Now, let's consider the implications of each possibility.

Counting on a Cut: The immediate impact of no rate cut at all will be for the stock market to fall out of bed - starting so quickly after the 2:15 p.m. announcement that some Wall Street Wag will dub it the "mid-afternoon swoon." The reason: The stock market has been counting on a cut, not so much to bail out Wall Street as to stimulate economic activity and get corporate earnings moving again. In this case, the asset deflation will continue.

Your best bet will be to invest in places with high liquidity and little exposure to the U.S. debt markets - Japan, Korea, Taiwan and Singapore are the obvious places.

[If you aren't already a Money Morning subscriber, you really should sign up; doing so will provide you a copy of our free 6,000 word investment report: "Global Investing: The Three Best Investments in Asia." Having researched and written most of that report myself, I can attest to the fact that it's a very thorough look at the best places to invest in Asia, even during these uncertain times. Click here to see more].

The advantage of this "no-cut" strategy is that it gets the problem over with - immediately. Massive amounts of capital have been invested poorly, misdirected, or just plain frittered away; that needs to stop, and the bad investments need to be liquidated.

The U.S. economy would probably drop into a recession fairly quickly, and lots of workers would lose their jobs. But the downturn, though sharp, would probably be short-lived. Inflation would remain under control. And both oil and commodity prices - hotter than a meteorite in recent months - might be able to cool off and even decline somewhat in price, as the recession blunts U.S. demand.

Once the initial panic drop has happened, say in about 2 weeks, investors should look at something like the streetTracks SmallCap Japan ETF (JSC) which, consisting of smaller companies, is focused on the liquid, credit-crunch-free domestic Japanese market.

Fed surprises with a big cut: At the opposite extreme, if Team Bernanke cuts the Fed Funds rate by half a point - or even more - the U.S. stock market would rebound sharply, and might even soar. But that surprise rally won't last for very long; reality will sink in as investors begin to realize that Bernanke hasn't solved the pesky debt problem, and in fact may well have done some serious long-term damage to the U.S. economy - or, at least, caused damage that will take some time to repair.

Even so, the U.S. and other economies abroad will roll on down the highway, perhaps even accelerating a big, as renewed short-term confidence temporarily re-ignites the mergers market.

By my calculations, the "re-flationary" effect of a particularly sharp rate cut might last about a year, before soaring commodity prices and inflation generally cause a deeper recession and a worse long-term financial problems. If this happens, one investment will scream out: Gold.

In real terms, today's equivalent of gold's all-time high in 1980 is about $2,000 an ounce; gold closed last week at $709.60 an ounce. I'd bail out at around $1,500 just in case, but that would still give room for a doubling in price from today's level.

[For another perspective on gold's potential upside, take a look at our recent investment analysis: "The Baywatch Effect: Can China's Growth Help Gold Prices Triple?"].

Probably the most efficient way to make this play is through the IShares Comex Gold Trust (IAU), which has $1 billion in capitalization and, thus, decent liquidity.

Needless to say, since the middle-course - the quarter-point rate cut and the stern lecture on the dangers of inflation and speculation - is the one that doesn't really offer any very interesting investment recommendations, it's probably the one Bernanke will choose.

The investment arena may well be the one place on earth where that bit of pop-culture advice courtesy of Meat Loaf ("Two Out of Three Ain't Bad") just doesn't ring true. And when translated into Japanese - as the cover of that hit single shows - the song title translates to: "66% Ain't Bad."

Let's hope the Fed's action today isn't equally as Lost in Translation.

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