The Halloween Fed chased away the market’s ghouls with a 25 basis point cut as expected.  On Monday, the financial markets had priced in a 100% probability of a 25 basis point cut and about a 25% probability of a 50 basis point cut.  Yesterday the markets had shifted to a 70% chance of a ¼ point cut, 12% odds for a ½ point cut and 18% chance of no change.  Clearly, the Fed wants to communicate with clarity and does not want to surprise the markets.  Hence, we got the ¼ point.

The Fed statement is an attempt to get to neutrality.  That is why the risks are stated as balanced.  We believe they are not balanced and, therefore, we expect the Fed will cut rates again.  We expect the Fed Funds rate to bottom at 4% before the cutting cycle is over.  If the economy worsens beyond our mild slowdown, soft landing scenario, the Fed will cut repeatedly and Fed Funds will have a 3-handle.

The risk of a hard landing is growing every day.  The Fed knows it and everyone else knows it.  The reason lies in the $21 trillion asset class of housing. 

In this largest of American’s wealth sectors the deterioration is worsening.  The accelerator is to the downside and there is not a bottom in sight.   That means risk is increasing every day as this asset classes shrinks in value. 

The Fed is now worried and does not want to see a recession.  So far there is none in sight but the Fed knows this is a dangerous situation.  

How bad is housing?  Really bad.  Consider this list: 

The homeowner vacancy rate is at the highest level in decades and is up a full percentage point in less than two years.

1. Homeownership is declining from its peak in the middle of 2004.  Why?  Foreclosures are reducing the homeownership rate.  It has been falling for four consecutive quarters.  This is the longest string of negative numbers since this statistic started in 1980.
2. Futures prices on the Chicago Mercantile Exchange point to lower housing prices and the rate of decline is steep.   No market shows a flat price let alone an increase.  This is clearly now a national phenomenon.
3. Completed new one family homes for sale are at a record high.
4. The number of months supply of homes for sale is the highest it has been since the 1980-81 recession and the trend is up.
5. Sales of new and existing homes combined hit their steepest falling rate in a ¼ century.
6. The Census Bureau’s Index of quality adjusted prices is negative and plunging to a new record rate of decline.
7. The National Association of Home Builders sentiment index reached its lowest level in its history.
8. The recent GDP report showed residential construction taking more than 1% out of GDP; this will get larger as the next few quarters unfold.

The Fed cannot change the near-term outlook for the housing sector.  It can only try to mitigate the damage in the future.  By future we mean the second half of 2008 and 2009.  Meanwhile the Fed is dealing with a major change in expectations.  When prices are falling home buyers wait because they believe that they will make their purchases at a cheaper price in the future.  In addition, they do not want to borrow and pay interest for an asset that is declining in price.  They are aware that the house price deflation has created an onerous real interest rate.  That is common sense.  Would you pay 6% to finance something that was falling in price at 6% per year?  In that case the real interest rate is 12%.

Housing deterioration may come into play in the presidential campaign.  While politics is currently not a direct issue for the Fed it could become one.  52% of foreclosures are in three states: Texas, Florida and California.   Presidential elections can be decided by any one of the three as we know.  The foreclosure rate is an indicator of how bad the housing decline has spread.  In those three states a contraction in housing wealth is severe and that could trigger political pressure for federal fixes.  Speculative query: Could housing be the sleeper in the election cycle that lets one of the parties become strong by bailing out the households and stemming the decline in value?  I see a big federal fix coming.

Deteriorating housing can spread to a recession and that may lead to changes at the Fed.  Remember the next president gets to appoint the Federal Reserve Chair.  Will Bernanke survive if we have a recession and if the foreclosure rate is climbing?  He becomes an easy target for presidents, Clinton or Giuliani or Romney or Obama.  What will markets do if they start to believe the Fed will change leadership?  We could see more discussion of Bernanke and the Fed as election 2008 unfolds. 

The housing crisis alone is bad enough but another shock is in the making.  High oil and energy prices are a second worry for the Fed.  They know that energy costs eat into disposable income at a time when the same disposable income has to pay a rising interest rate on mortgages that are resetting two percentage points above the inception rate set a few years ago.  

Add energy and housing together and the situation can become bleak.   In the near term the Fed cannot do anything about the energy costs just like it cannot turn the housing decline around.  But the Fed’s actions today can mitigate the future damage.  With inflation risk subsiding and the rate of inflation low, there is no reason for the Fed not to take out insurance to protect the future of the general economy.  That is why we look for more rate cuts ahead.

A final note: there is a question circulating in the financial community.  Is the US economy decoupled from the world’s emerging market economies so that the global growth story can remain even as the US slows due to the housing crisis and the sub-prime mortgage finance debacle?   This is a tough one.  Both sides may be argued.  And China is the largest of the emerging economies and holds the largest reserves.

We want to see this first hand so we are joining a group of economists and financial market colleagues for 10 days in China.  We leave on Friday.  The trip is a combined effort of the European Council of Economists and the National Business Economics Issues Council.  I am a member of the latter.  The group is assembling from around the world and will have several days of business meetings in China discussing the global outlook. In addition, we will have a chance to meet privately with Chinese officials and academics and financial market agents.  We expect to have substantive conversations in Beijing, Shanghai and Hong Kong and hope to report findings when we return.

Please note that Cumberland clients are invested China and Hong Kong in their international ETF portfolios.  We have taken some profits in those positions.  We have avoided the housing and home building sectors and continue to do so.  We are also avoiding mortgage finance and have remained under weight in consumer discretionary.  We have a maximum over weight position in the technology sector and believe that a long bullish and robust tech cycle lies ahead.