Fed explains the big rate cut

NEW YORK (CNNMoney.com) -- The Federal Reserve cited an "exceptionally weak" housing market and concerns that this summer's credit crunch could lead to a pullback in consumer and corporate spending as reasons for its decision to cut interest rates by a half percentage point on Sept. 18, according to minutes from the meeting released Tuesday.

The minutes showed just how seriously the Fed viewed the mortgage meltdown, which caused massive bouts of volatility in the stock and debt markets over the past few months.

The Fed said that a half-point rate cut, rather than the more conservative quarter-point cut that some investors were expecting, was "the most prudent course of action" in order to "help forestall some of the adverse effects on the economy that might otherwise arise" from deteriorating conditions in the credit markets.

However, it is uncertain what the Fed's next move will be when it meets again to discuss interest rates later this month.

Quincy Krosby, chief investment strategist for The Hartford, said that those in the "one and done" rate cut camp can point to the Fed's comments about inflation as a sign that the central bank wants to hold pat instead of cutting rates again.

At the same time, Krosby said it was telling that the Fed pointed out it felt "further slowing of employment growth was likely." That could be an indication the Fed is more worried about weaker economic growth than it is about inflation - signaling a reason to lower rates.

The government reported last week that the unemployment rate in September ticked up to 4.7 percent. Since labor costs are a major factor in determining inflation, it seems that the Fed would have less reason to be worried about pricing pressures in the coming months.

Stocks, which were mixed before the minutes came out at 2 p.m. ET, moved to their highest levels of the day following the release of the minutes as investors apparently interpreted the Fed's concerns about the economy as a sign that more rate cuts are on the horizon.

The Dow, which ended up more than 120 points or nearly 0.9 percent, and the S&P 500, which finished with a more than 12 point or 0.8 percent gain, set records. The Nasdaq rose 0.6 percent.

"The Fed acknowledged that the employment situation is slowing and that the economy is not producing as many jobs," Krosby said. "That gave some people hope that further easing is in the cards."

Last month, the Fed lowered its federal funds rate, a key overnight bank lending rate that determines what consumers pay on various types of loans, to 4.75 percent.

The central bank's policy making committee will announce at the conclusion of its next meeting, a two-day session that ends on Oct. 31, whether or not it will once again lower the federal funds rates.

According to futures listed on the Chicago Board of Trade, investors are pricing in the strong likelihood of at least one quarter of a percentage point rate cut between now and the end of the year. The Fed's final meeting is scheduled for Dec. 11.

However, the probability of a rate cut is not as high now as it was immediately after the Fed cut on Sept. 18. At that time, investors were pricing in a nearly 100 percent likelihood of a rate cut on Oct. 31.

To that end, bonds slipped after the minutes were released Tuesday, pushing the yield on the benchmark U.S. 10-Year Treasury note up to 4.65 percent. Bond prices and yields move in opposite directions, and typically rising yields are an indication of economic strength and a rising interest rate environment.

Joe Balestrino, a senior portfolio manager for fixed income investments at Federated Investors in Pittsburgh, said that bond investors seem to be indicating that another rate cut before the end of the year is no longer "a lock" since the Fed also indicated in the minutes that is continuing to keep a close watch on inflation.

This might not be a bad thing though, he continued. He said investors may be coming to the realization that the Fed's half-point cut may keep the economy from sliding into a housing-induced recession and that the worst may be over.

"One could conclude that order has been restored to the financial markets. This may be just a growth slowdown with modest inflation," Balestrino said, adding that this is a "quasi Goldilocks" scenario similar to the mid-1990s.

In 1994, bonds and stocks had a rough year due to what Balestrino called "fears of a recession that never happened." The markets went on to experience several strong years of growth for the rest of the decade before tech stocks crashed in 2000.

Brian Stine, investment strategist with Allegiant Asset Management Co. in Cleveland, agreed that this could be similar to the mid-1990s. He said the main reason the stock market rallied on the Fed minutes is because it seems that the Fed has things under control.

"On the one hand, the Fed seemed to indicate that we're not headed for a recession but that they also think the outlook on inflation has improved. This is the path the Fed wants us to go on - moderate economic activity with inflation abating," Stine said.

Still, some are holding out hope for at least one more rate cut by year's end.

Matthew Smith, president and chief investment officer with Smith Affiliated Capital, an investment advisory firm based in New York with $1.7 billion in assets under management, said another reason investors may have taken comfort from the minutes is because another rate cut could mean that the dollar will remain relatively weak versus other currencies.

And while this would be a bad thing for bonds - a weak dollar makes Treasurys less attractive to international investors - the weak dollar should boost stocks, Smith said. That's because international investors will be drawn to large U.S. firms with significant operations overseas that will see profits rise.

"A weakening dollar is a positive for stocks since you get foreign investors coming in and there is a potential boost to earnings for multinational companies," Smith said.