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SCMP Reporter

A familiar rallying cry from bullish stock market strategists is 'Don't fight the Fed'; they mean that if the Federal Reserve is cutting rates we should be buying stocks and taking on more financial risk.

Let us lift the bonnet and delve into the financial works to explain what they are getting at.

When the Fed, or any other central bank for that matter, cuts interest rates it is essentially making a commodity called money cheaper. When a commodity gets cheaper, demand for it goes up in a normal economic environment.

With last week's surprise reduction from 5 per cent to 4.5 per cent of the Fed funds rate, banks will be able to take more money from the interbank market or the Fed and pass it on to customers.

For example, a bank might borrow US$100 at 4.5 per cent from the Fed and then perhaps pass on $80 of that to short-term customers at 5 per cent, turning a quick profit, said Sean Darby, Asian strategist at Dresdner Kleinwort Wasserstein.

The Fed has effectively been pumping money into the financial system by raising demand for it through lower rates.

This year, liquidity in the United States has surpassed that seen during the scares over Y2K and the collapse of the giant hedge fund Long Term Capital Management in 1998.

But most of that extra money has been parked in short-term money market funds rather than being used to fuel rallies in stocks and bonds, regional strategist for Salomon Smith Barney Han Ong said.

There was a run up in markets after the Fed began cutting rates with its inter-meeting January 3 reduction of 50 basis points.

But investors have for the most part felt happier making a risk-free 4 or 5 per cent in money funds than taking a risk buying bonds and stocks.

That was because investors believed the Fed was not cutting rates quickly enough to prevent a recession and deflation in the rapidly slowing US economy, Mr Ong said.

In particular, the Fed failed to deliver the 75 or 100 basis-point cut markets were looking for from its March 20 meeting.

'People didn't like what the Fed was doing,' Mr Ong said. 'They thought the Fed was behind the curve.'

Last Wednesday's surprise cut of 50 basis points has restored faith that the Fed will keep its promise to do whatever is needed in terms of rate cuts to prevent a recession.

That can be seen in the yield curve for US Treasury bonds. It has begun moving out of the unusual situation of being inverted, with a higher yield for short duration than longer duration issues, effectively pricing in a recession.

Since the cut, the yield curve has turned positive once again as investors start believing that gloomy scenario will not play out.

Not only have short duration bond investors found their returns shrinking but so have investors who put their money in cash.

These investors will now consider shifting to assets with higher risk and yield.

Some of the assets they would look at were Asian equities which were towards the higher end of the risk spectrum, Mr Ong said, particularly if the Fed cut rates by a further 50 basis points at its May 15 meeting which 'could finally normalise the curve'.

'A normal US yield curve is good for Asian equities,' Mr Ong said.

With the Fed having pumped out so much liquidity and with so much of it sitting on the sidelines in cash funds, when the money does move into risky assets it can be violent.

The point was underlined by the Nasdaq Stock Market's supercharged rise of 33.57 per cent in 10 trading days, with the rate cut adding to perceptions that technology stocks were oversold.

Managers' psychology is also at work in markets. They do not want to be left behind in any rally having already lost their clients large amounts of money last year.

A proprietary trader with a European bank said there was some truth to the argument that lower rates would get investors moving to riskier Asian assets but those assets were more likely to be bonds than stocks.

Yields looked attractive. For example, bonds of state-run Korean power firm Kepco yielded 272 basis points over US Treasuries, according to JP Morgan.

The trader said with stocks 'the earnings just aren't there', to take on the higher risk even if there was more money sloshing around.

'If you talk to Cheung Kong or Sun Hung Kai Properties they tell you it is going to be a difficult environment.'

Annual earnings growth in Asia made big jumps in 1999 and last year thanks to easy comparisons with the crisis years. From now on they would return to a more normal 5 to 8 per cent. That did not justify present stock valuations where a price-earnings ratio of 15 to 20 was considered normal, the trader said.

He saw short-term opportunities in 'beaten up' technology stocks in South Korea and Taiwan stocks but said positions would probably be cut after four or five days.

'You have to take what sell side analysts say to you with a pinch of salt,' the trader said.

JP Morgan is also sceptical that the cheerier tone in bond markets presages a move into riskier Asian assets. It expects the US economic outlook to weaken 'as cost pressures and poor pricing power continue to squeeze profits'.

While the Fed will cut rates to 3.75 per cent by June, the gloomy economic backdrop will mean investors will continue to favour safety over risk.

Graphic: us24gbz



Fed cut seen favourable to 'riskier' Asian stocks