The Fed, Freddie Mac, and AIG

Let's see, where do we start? The Fed didn't cut rates. No surprise there. They are handcuffed between spiraling inflation (headline inflation is at a 27 year high and core inflation is well outside of their 2% upside target), and a very weak economic outlook. Unemployment is approaching 6% and the housing market shows no sign of an upturn. If anything, I could see them cutting if the outlook gets much worse. It is worth pointing out that according to academic economics (which most of the Fed governors are devout followers of), inflation which is derived from rising commodity prices is outside of the control of monetary policy and should be treated as a one-time shock. This means that (according to academia) they should not adjust monetary policy to address the inflation the U.S. is experiencing. While I am not here to argue whether or not academia is correct in this thinking, it is an interesting thought to consider. I don't really see any action any time soon, because I feel the Fed wants to keep some "dry powder" if things really start weakening. I forecast 2% being the Fed Funds target rate into 2009. It should be pointed out that the Fed Fund futures do not agree with my analysis, as they are anticipating a probable hike in one of the next two months.

Freddie Mac and AIG brought more bad news to the financial sector this week, posting losses well in excess of forecasts, with FRE losing over $800M and AIG losing in the range of $5.4B. I was in no way surprised by FRE's results, actually part of me was surprised they weren't worse, but I must admit I didn't see AIG coming. They had unrealized losses of $5.57B on their "super senior credit default swap portfolio". I don't like this at all. First off, what is an insurance company doing in the credit default swap market? Second, why were they on the wrong side? I must admit, long term, they will probably be able to write this portfolio back up once the value of the swaps decline, but they may have to take another big writedown next quarter. Makes me wonder how the are going to be able to meet obligations from any big disaster in the short term...

I think I see some pessimism creeping back into financials. But I am bearish, so perhaps I am just seeing want I want to see here. But I can't see the price of oil falling much below $115, so I see the crude-driven rally fading here.