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The Calm Before The Storm?Low Volatility, Low Volume, Good Housing News May Set Stage For A Wild September

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We’re headed for a record low-volume trading day at the New York Stock Exchange, with the major indexes slightly up but mostly “range bound,” as they say. London is heading into a three day weekend, and it looks like a lot of people on this side of the Atlantic have just decided to take today off.
One of the things that has the markets so sanguine is the widespread expectation that the Federal Reserve will cut its target for interest rates. But there a lots of signs that this expectation may be built more on hope and faith than realistic assumptions. We’ve been told by an economist who is familiar with the thinking inside the Fed that the widespread assumption that the Fed won’t disappoint the markets is a contrary indicator: the Fed is eager to prove that it is not a servant of Wall Street and is instead basing its monetary policy on the goal of achieving sustainable, low-inflation growth in the broader economy.
And the broader economy seems to be doing quite well. Sales of new homes in July exceeded expectations. There’s no signs of rising unemployement. And despite a few well-publicized cases, the much feared mortgage credit crunch has not yet thrown a generation of Americans out of their homes. We’re not a nation of Tom Joads and it doesn’t look like we’re about to become one either.
There are serious problems with the credit markets but these are largely not problems the Fed can fix by lowering interest rates. The underlying problems are really rooted in collateral valuation. This is what is hitting the leveraged buyout market—bankers wondering whether the companies whose buyouts they are financing are really worth what the private equity guys claim. This is what is hitting the market in collateral debt obligations. This is what has stopped up the flow in commercial paper.
The Fed probably can’t fix the collateral valuation issue. It can only pour enough money on the economy to make it harder to properly calculate the values of assets, increasing the chances for capital misallocation. This isn’t our view, it’s the view that sources familiar with the thinking of several members of the Open Markets Committee say may be dominant.
All this doesn’t sound like a recipe for a Fed cut in September. Things could change. But it is starting to look like Wall Street might be getting ahead of itself by baking in a rate cut. Which means that we might be in for another wild ride in September if the Fed refuses to take its orders from Wall Street.