Ok, just a warning before reading any further, if you are having a good day, don't proceed as this post may be a little disturbing...

In the last several week the FED has cut the target overnight rate by 125 basis points.  It's the most they've cut in a single quarter in the last twenty or so years.  If you don't understand why I've bolded target you may want to go back and read one of my previous posts (rants) Why does no one in the media understand The FED?

Basically the FED does not in fact set interest rates, only sets are target for overnight lending rates among banks and in fact is not even in the drivers seat in this respect but follows the demand for credit.  They then defend this target by adding or removing liquidity (loans) from the banking system daily.  The amount of liquidity the FED has contributed to the system is often referred to as "slosh".  When the target rate becomes hard to defend because it either requires adding or removing too much liquidity the they are forced to change the target rate.

This is what happened immediately prior to their surprise 75 BPS cut a few weeks ago, the demand for credit in the banking system plunged so they had to cut the target steeply to avoid having to remove to much money from an already wounded banking system.  The problems in the equity markets prior to the cut were in large part caused by this credit demand plunge.  This of a case of correlation does not equal causation.  The FED didn't cut because the stock markets were tanking but rather the same factor required both the cut and and caused the stock selloff.  Of course the media immediately links it to the stock sell off, because they tend to watch stock markets and pay little attention to the less sexy and less transparent credit markets.

Now here's where it gets scary, despite the 125 basis points of cutting, the slosh in the system is dropping, the FED is REMOVING liquidity from the banking system.  In fact the slosh is now down to only $16B (+ TAF actions), where for much of the fall it was above $50B.  And yet yesterday the overnight lending rate last night was a full 18 basis points BELOW the target rate.  What?   

Basically the ramifications of this is credit demand is completely collapsing.  There are many other metrics where this can also be observed.  The FED maybe forced to cut the target again in the not so distant future simply to avoid having to pull more money from the banking system.

Now why is credit demand collapsing?  Lending is drying up, despite the lower price of funds, banks are afraid to lend thus don't need to borrow as much.  Some of the ones in more dire straights also don't have the collateral to take on additional funds hence why they are going and taking money from Middle Eastern investors at payday loan rates.  That's actually a good tip off, why does Citigroup or Merrill Lynch, etc go pay 12% rates to outside investors when they can get money much cheaper from the FED?  The answer, they don't have the collateral/reserves space available to borrow elsewhere.   

So what does this all mean? 

The target rate is more than likely going lower, much lower.  Yet, at the same time lending will continue to tighten.  Banks won't/can't lend further and their borrowers will have less demand for credit.  We are possibly seeing the start of what economists would refer to as a deflationary credit collapse.  This is what happened in Japan starting in the late 1980's, which was incidentally triggered by the popping of their real estate bubble.  Once these things get going they are nearly impossible to stop, and result in further and further contraction of credit and asset price declines among pretty much all assets (real estate, stocks, commodities, etc)

Yup scary stuff.  I'm not trying to be alarmist, I'm just pointing out what I see happening based on the data...

Update: After the effective funds rate trended way below the target rate for three days, it has now started to stabilize a bit, this is good news.