Will The Fed Cut Rates Again?

Next week the Fed will meet for the last time this year. The Fed Funds rate now stands at 1.00%, the same level it was at during the last recession (and for a long time after that recession was over) and as low as it has ever been. However, the odds are that the fed will spend most of its remaining ammo and cut it sharply next week.

According to the Cleveland Federal Reserve, which calculates the implied probabilities of Fed moves from the futures markets, there is now about a 65% probability that the Fed Funds rate will be cut all the way to 0.25%. There is also a 20% chance it goes all the way to zero. Click-click, the Fed is out of ammunition. The only thing left for it to do is to resort to unsterilized buying of longer dated T-notes, which is sort of a fancy way of saying, “Turn on the printing presses!”

Monetary policy has done everything it can; now a very expansive fiscal policy is the only hope of getting the economy moving again. Right now, fiscal policy is already quite expansionary by any normal measure. Today we learned that the Federal Budget deficit was $164.4 billion — not for the year, but only for the month of November. This comes on top of a $237.2 billion deficit in October, to bring the deficit so far in this fiscal year (ends 9/30/09) $401.6 billion.

While it is not quite valid to simply extrapolate out that rate (for example, there are some months like April, when the government normally runs a surplus) but if one were to do so, it would indicate a budget deficit for the year of over $2.4 Trillion, or over 17% of GDP. In reality, we are probably looking at a deficit of more than $1 Trillion, which would exceed the worst deficits of the Reagan era as a percent of GDP by a very unhealthy margin. Keep in mind this is before the Obama stimulus package is factored in.

In this context, the current pricing of T-notes and bonds is far more irrational than $147 a barrel oil or $600,000 3 bedroom, 2 bath houses in only a so-so neighborhood. At current rates (1.61%) on the 5-year note, it would take 44.7 years for your money to double using the rule of 72. The picture is only slightly better if you are willing to lock up your money for 10 years, where the 2.66% rate would result in a doubling in 27.1 years. For the 30 year bond the rate is 3.06%, or a doubling in 23.5 years.

While the current problem is deflation, there is a very real possibility that the result of the current policies will result in very high inflation in a few years. It is worth considering putting part of your portfolio into inflation beneficiaries. Consider gold mining stocks like Barrick Gold (ABX) and Newmont Mining (NEM) and –  at all costs — avoid the Treasury market unless you are a very nimble trader. Treasuries are NOT safe.

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