Friday, December 14, 2007

This weeks U.S. interest rate cut causes a stock sell-off

U.S. federal interest rate cut spurs stock sell-off

Fed lowers benchmark rate quarter-point to 4.25%, markets slump as hopes of bolder reduction dashed

Investors expecting an early Christmas present from the U.S. Federal Reserve saw their hopes dashed after the central bank announced a modest quarter-point cut to its benchmark interest rate and signalled it is keeping its options open on further cuts in 2008.

While yesterday's cut was in line with most economists' forecasts, Wall Street was hoping for a more aggressive half-point reduction to prevent America's housing and credit woes from pushing the world's largest economy into a full-blown recession. The federal funds rate, at 4.25 per cent, is now at a two-year low.

But that did little to placate nervous traders who punished stocks, taking square aim at financial issues.

Wall Street sustained the heaviest losses with the Dow Jones industrials plunging 294.26 points to 13,432.77. Bay Street was also swept up in the sell-off as the S&P/TSX composite index lost 216.65 points to 13,723.71. The Canadian dollar, meanwhile, shed 0.83 of a cent to 98.58 cents (U.S.).

"When the central bank cuts rates and financial stocks still sell off sharply, that gives you a sense that there is a lot of nervousness out there about the health of the financial sector," said Michael Gregory, senior economist with BMO Capital Markets.

Americans have been given plenty of reasons to worry in recent weeks. The Mortgage Bankers Association reported that U.S. home foreclosures hit an all-time high in the third quarter, suggesting the housing downturn is hurting a wide range of homeowners and not just those with subprime mortgages.

On that front, about $400 billion worth of subprime mortgages are scheduled for interest-rate resets beginning in 2008. Several big-name American banks have already disclosed hefty losses related to the subprime market, which targets clients with spotty credit histories. While the U.S. government recently announced a bail-out plan for some subprime borrowers, critics say the interest-rate freeze will only provide limited relief.

Meanwhile, the Fed announced it would hold a meeting next week to propose changes to mortgage regulations to address unfair and deceptive lending practices.

"You've got this outright home-price deflation in the U.S.," Gregory said. "It is affecting all homeowners and even those with very good credit, very good jobs are having a tougher time getting loans."

While lower interest rates may be the quick fix, the Fed is mindful that if it cuts rates too quickly it runs the risk of once again inflating asset prices, Gregory said. Yesterday's rate reduction follows a similar quarter-percentage point cut in late October and a bolder half-point cut in September.

"Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks," the Fed said in its statement. "Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time."

The Fed also noted core inflation readings have "improved modestly this year" but it's still concerned about higher commodity prices.

For their part, equity investors are fixated on lower rates because it makes it cheaper for businesses to borrow money, buttressing earnings and stock valuations.

The Fed also lowered its discount rate, the rate at which it lends to banks, by a quarter-point to 4.75 per cent. Traders were disappointed the spread between those two key rates was not narrowed more substantially.

"They maintained the discount rate spread of 50 basis points, which either indicates they don't regard the strains in the money market as a significant risk, or that an aggressive reduction won't do much good," Scotia Capital economists wrote in a commentary. "Neither explanation does much for the market's confidence."

Last week, the Bank of Canada cut a quarter-point from its key overnight rate to 4.25 per cent. Most economists expect the Fed to cut rates more aggressively than the Bank of Canada next year.

"We expect the Fed will be ready to cut policy rates again if economic and financial market conditions warrant and forecast another 50 basis points of rate cuts (in two 25 basis point increments) in early 2008," said Dawn Desjardins, senior economist with RBC.

That should stimulate the U.S. economy and stabilize American demand for Canadian-made goods, said Charmaine Buskas, senior economics strategist with TD Bank.

But not everyone is convinced the U.S. is teetering on the brink of a recession. Jeff Rubin, CIBC's chief economist, believes the American economy will "re-accelerate" in 2008, spurring North American stocks to new highs. He predicts the TSX composite index will hit 16,200 by the end of next year.

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