Income Strategy September 21, 2007:

The Federal Reserve caught the market by surprise when it announced a 0.5% reduction in both the Fed Funds Rate and the discount rate. This is the first decline in the Fed Funds Rate since June 29, 2006. Most analysts expected a 0.25% decline on both the Funds and Discount rates. The larger than expected rate reduction triggered a rally in both the stock and bond markets as investors looked at the Feds move as the beginning of a series of aggressive interest rate reductions coming over the next few meetings. There seems to be very little concern in the markets that the Feds most recent move could be the initial trigger for much higher inflation rates over the next 12 to 18 months.

The Federal Reserve appears to be following the set course when financial turmoil hits the global markets, it lowers rates to bail out investors and investment firms in order to soften the potential economic impact of any excesses that have developed in the economy. The cumulative effect of these short term bail outs that have taken place over the past twenty years is that investors now have very little respect for risk, as there does not appear to be any over a longer term time frame. Investors who can weather the short term volatility have been very well rewarded by the actions of the Federal Reserve over the past 2 decades.

The recent increase in volatility has already started to decline back in to a more normal range as investors realize that the fed has bailed out investors again and it is safe to jump back in to the market. It will be only a relatively short period of time before the bond markets globally have shrugged off this most recent set back and then they will be on to the next new leveraged buy out or carry trade.

I have a feeling that the current sense of investor invincibility is going to lead to an extremely expensive and long lasting blowup. That will impact on North American investors and borrowers for an extended time possibly as long as two years. The negative impacts of poor lending practices compounded by excessive leverage which has been exported globally is not even close to being fully felt by the North American markets. Now is not the time to re-enter the bond market as there are many opportunities on the horizon which will be very rewarding for those investors willing to wait.