The reaction of the stock market to the unexpected 75bps cut by the Fed last week and its reaction today to the further 50bps cut clearly shows that markets and investors are now fully realizing that the US economy is suffering from serious credit, i.e. insolvency, problems, not just illiquidity ones; and that Fed monetary policy can partly tackle illiquidity problems but cannot resolve insolvency ones.

Last Tuesday when the Fed unexpectedly cut the Fed Funds rate by 75bps the US stock market fell by over 1% in spite of that cut (but by less than the 5% that the futures had priced before that surprise cut). The next day – Wednesday – the S&P tumbled by another 2.5% for most of the day giving the market verdict on the Fed action: too little, too late and useless to resolve the massive credit problems in the economy, including the serious market concerns that a downgrade of the monolines would lead to massive financial write-downs and  a financial meltdown. The late day whopping rally in the last two hours of trading on Wednesday last week – 600 points on the Dow and over 5% on the S&P – was triggered instead by the news that the New York insurance regulator had met with banks to try to work out a plan to recap the monolines and thus avoid a catastrophic downgrade of their triple AAA rating. So that day the market told the Fed (with a 3.5% stock market drop following the rate cut): your 75bps cut means practically nothing to us and unless the credit problems of the economy are resolved. And the 5% rally was indeed triggered by news that maybe the monocline downgrade could be avoided.  

Same story – in reverse - today Wednesday after the additional 50bps cut by the Fed. The initial reaction of the stock market was a relief rally – with the S&P500 index up about 1.7% after the Fed announcement and its signal of more monetary easing ahead. But this rally totally fizzled again in the last two hours of trading as reality sank in that the rescue of the monolines is much harder than hoped for after Fitch revoked its top AAA ranking on Financial Guaranty Insurance Co, one of the bond insurers.  So the S&P fell from its day peak by 2.2% and finished the day 0.5% below its opening level in spite of the 50bps gift by the Fed and in spite of the fact that the Fed had reduced policy rates by a whopping 125bps in eight days!

So both following the 75bps cut last week and the 50bps cut today the stock market told the Fed: “it’s not just an illiquidity problem; it’s most importantly a credit or insolvency problem we worry about, stupid!” And the market reaction on both occasions highlights the relative impotence of monetary policy in addressing credit problems. 

Let me elaborate on these issues and also discuss how the problems of the monolines are now at the core of the markets, of the financial regulators and of the Fed’s concerns about the risk of a catastrophic financial market’s meltdown….