Market Buzz: Why Investors Might Not Want Another Rate Cut

Investors may soon get what they are clamoring for: a cut in the benchmark federal funds rate. But they should be careful for what they wish for.

Economists say that if the Fed cuts the overnight bank lending rate before a scheduled Sept. 18 meeting, it would result from the near-panic market conditions seen last week.

"The Fed would rather wait," says Gary Schlossberg, senior economist at Wells Fargo Capital Management. "But if the market doesn’t respond well--if we start to see a selloff and enough turbulence--the Fed will come in."

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The fed funds rate has been perched at 5.25% since June 2006. More than half of U.S. primary dealer banks polled by Reuters now predict that Fed policymakers will lower the key rate at its September meeting, if not before.

What would cause another market meltdown and force the Fed to act immediately? Market pros say the primary danger remains in the credit markets, which are still reeling from the growing problems in the subprime mortgage market.

"It's the Credit Market"

"It's not about the stock market right now, it's about the credit market," says Arthur Cashin, UBS director of floor operations. "The stock market is on hold waiting to see if the discount-rate cut filters through the credit markets and if safety breaks out."

The Fed surprised the markets on Friday by cutting the so-called discount rate, which is what it charges banks for short-term loans, to 5.75% from 6.25%. But the discount rate is considered more symbolic than the widely watched fed funds rate, which has a direct impact on banks' prime lending rate, the benchmark for millions of consumer and business loans.

What's worrying the markets is that the tightening of credit has now spread to the commercial paper market, where companies get short-term financing for ongoing operations. If credit dries up for those borrowers, it could trigger the type of financial crisis that hit the markets in 1998 with the failure of the hedge fund Long Term Capital Management.

"In the asset-backed commercial paper market, people just don’t want to deal with each other," says Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi. "Borrowers and lenders are not meeting and are hoarding cash."

Part of last week's near-panic was prompted by a run on branches of Countrywide Bank after parent Countrywide Financial

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[CFC  Loading...      ()   ], a big mortgage lender, was forced to borrow $11.5 billion on Thursday because it couldn't raise short-term cash to keep making home loans. Some market watchers think the Fed could be forced to act again if more big mortgage lenders run into similar problems.

Flight to Safety

This worry about a worsening credit crunch has prompted more investors to flee to the relative safety of the Treasury bond market.

"A glaring sign of continued market strain is evident in the T-bill market, where yields are below last week's closing lows," says Tony Crescenzi, chief bond market strategist, Miller, Tabak. He predicts a half-point cut in the fed funds rate if "the psychotic atmosphere of last week returns."

From a stock market perspective, Sam Stovall, chief investment strategist, says "markets responded favorably to the Fed’s action, as it sent a message to investors that the Fed will do whatever it can to alleviate the lending paralysis brought on by the fear surrounding the spread of the sub-prime worries."

But Stovall has cautious words for those who think shares are "on sale" following the cut in the discount rate.

"Use history as a guide," says Stovall, "but not gospel this time around. The rate reduction relieved the tension surrounding the credit crisis, but has not removed the underlying concern surrounding the economy and the stock market."