This mess isn’t over!

If there was any doubt left in anyone’s mind about the seriousness of the credit crunch that caused stocks around the globe to plummet, the U.S. Federal Reserve Board dispelled them on Aug. 17.

The Fed’s decision to suddenly cut its discount rate by a half point underlined the gravity of the situation. Prior to the unexpected announcement, which came just before the markets opened, Dow futures were down more than 100 points, signalling yet another rough day. After the news came out, everything turned around and by 10 a.m. the Dow was ahead by about 200 points and after some toing and froing during the day held on to those gains plus a little more to finish up 233.3 points. It was a similar story in Toronto, where the TSX finished ahead by just over 200 points for its first winning session since Aug. 7. That put us back in positive territory for the year by a slim margin and allowed everyone to breathe a sigh of relief.

The statement accompanying the Fed rate cut announcement reflected the deep concern within the U.S. financial community. The Fed, which is normally very cautious in its wording and parses every phrase with care, said that in the estimation of the Open Market Committee “the downside risks to growth have increased appreciably”. That was in sharp contrast to the Committee’s statement just 10 days earlier when it said: “The economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”

Talk about turning on a dime! The powerful U.S. central bankers have access to the kind of sophisticated intelligence the rest of us never see. Yet they were clearly blindsided by the speed and intensity of the international financial hurricane that has blown up. It is not unprecedented for the Fed to take this kind of action, but it is extremely rare. This kind of heavy artillery only comes into play in moments of deep crisis, such as after the 9/11 attacks.

Despite the initial positive response of the stock markets, which carried over to the next week, this does not mean the crunch is over. The Fed admitted as much in its statement, saying: “The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”

The next obvious move would be to cut the key federal funds rate, which is the one that has the greatest influence over consumer lending rates. The Aug. 17 cut was to the discount rate, which is what the Fed charges on loans to banks. It’s rarely used in the real world so the Fed was able to send a strong signal without in fact actually changing anything of significance.

After the news came out, I spoke by phone with Scott Lamont, head of the fixed-income team at Vancouver-based Phillips, Hager & North. He agreed that the Fed’s move is just “part of the process”. Unwinding the tangled web of heavily leveraged subprime assets in the financial markets will likely take at least three to six months and will probably require more intervention by the central banks, including rate cuts. As a result, we can expect to see stronger bond markets in the near term. However, he was nowhere near as bullish on the longer-term view.

“We see this as a mid-cycle slowdown rather than as something more dramatic,” Lamont said. “The downside of this slowdown will likely be worse than we expected but the economy is strong. We expect to see a return to upward pressure on rates in six to 12 months, which would mean weakness for bond prices.”

In short, bonds are a safe haven right now, but don’t get too bullish on them.

The recovery in the equity markets after the Fed announcement left many people feeling the worst may be over. But, as with an earthquake, we need to be wary of after-shocks. Where the markets go from here will be influenced in large part by how people feel about the future. If they decide to crawl into bed and pull the covers over their heads, watch out.

I have always believed that we should never minimize the impact of human psychology on the markets and, by extension, the economy. Central banks can tinker with money supply and interest rates and their actions will have an impact, as we saw on Friday. But if the person-in-the-street decides to cut back on spending and put all his/her money into paying off the mortgage, watch out. Prudent though such actions may be, they spell trouble for our consumer-driven economy.

That’s why one of the indicators I’ll be watching closely over the next few months will be the Conference Board Consumer Confidence Index, which samples 5,000 U.S. households. In July it hit a six-year high of 112.6 – and remember that the subprime mortgage issue was already front and centre at that time. In a statement accompanying the release, Lynn Franco, Director of The Conference Board Consumer Research Center, said: “Consumers are more upbeat about short-term economic prospects…This rebound in confidence suggests economic activity may gather a little momentum in the coming months.”

It would surprise everyone if the Index doesn’t dip when the August numbers come out. But if the drop is relatively small and the Index rebounds in September, that could be a sign that we may yet emerge from this mess with minimal damage.

Whatever happens, if you had not previously done some prudent portfolio rebalancing, this respite offers a new opportunity. Don’t get caught off-base twice.

Adapted from an article that originally appeared in the Internet Wealth Builder newsletter, edited and published by Gordon Pape. For information on a three-month trial offer, go to