Best of the Week
Most Popular
1.Bitcoin War Begins – Bitcoin Cash Rises 50% While Bitcoin Drops $1,000 In 24 Hours - Jeff_Berwick
2.Fragile Stock Market Bull in a China Shop -James_Quinn
3.Sheffield Leafy Suburbs Tree Felling's Triggering House Prices CRASH! - Nadeem_Walayat
4.Bank of England Hikes UK Interest Rates 100%, Reversing BREXIT PANIC Cut! - Nadeem_Walayat
5.Government Finances and Gold - Cautionary Tale told in Four Charts - Michael_J_Kosares
6.Gold Stocks Winter Rally - Zeal_LLC
7.The Stock Market- From Here to Infinity? - Plunger
8.Ethereum (ETH/USD) – bullish breakout of large symmetrical triangle looks to be getting closer - MarketsToday
9.Electronic Gold: The Deep State’s Corrupt Threat to Human Prosperity and Freedom - Stewart_Dougherty
10.Finally, The Fall Of The House Of Saud - Jim_Willie_CB
Last 7 days
Inflation is Spiking Globally… Bond Bubble Bursts in 3… 2… - 15th Dec 17
Sheffield's 'Real' LORAX Defending the Trees From the Labour City Council Patrol Units - 15th Dec 17
Stock Market Decline Signals are Near - 15th Dec 17
Santa Is Putting Christmas On The Blockchain And Saving Billions - 14th Dec 17
The Unprotected, the Protected, the Vulnerably Protected Classes—Which Are You? - 14th Dec 17
Gold’s Upside Target - 14th Dec 17
Year-end US Interest Rate Hike Again Proves To Be Launchpad For Gold Price - 14th Dec 17
2 Charts That Might Define the Fed’s Jerome Powell Era - 13th Dec 17
UK Stagflation Risk As Inflation Hits 3.1% and House Prices Fall - 13th Dec 17
Stock Market Elliott Wave Forecasts - Is the World coming to the end? - 13th Dec 17
A Method Traders Can Use to Confirm an Elliott Wave Count - 13th Dec 17
Best Time / Month of Year to BUY a USED Car is DECEMBER, UK Analysis - 13th Dec 17
A Former Wall Street Veteran: Good Traders Are Born, Not Trained - 12th Dec 17
Buy Gold, Silver Time After Speculators Reduce Longs and Banks Reduce Shorts to Continue? - 12th Dec 17
Masters of Economic and Political Illusion – in Taxes, Debt, Government, and Markets - 12th Dec 17
Approved Used Land Rover Main Dealer Real Customer Buying Guide - Hunters, Chester - 12th Dec 17
Gold Price 100% Bullish Signal - 12th Dec 17
Epic Stock Market & Fixed Income Bubble Will Not End Well - 12th Dec 17
Bitcoin can be stolen. Although Can’t be hacked - 11th Dec 17
Have Stocks Reached A Permanently Rigged Plateau? - 11th Dec 17
Trying To Beat The System Is A Fatally Flawed Investment Strategy - 11th Dec 17
Is This The Beginning Of The Next Silver Rush? - 11th Dec 17
The Dow Gold Ratio - 11th Dec 17
Evidence of a Stock Market Top Mounting - 10th Dec 17
Bitcoin Doesn’t Exist – Forks and Mad Max - 10th Dec 17
Bitcoin Doesn’t Exist – Putting the Banks Out of Business - 9th Dec 17
China’s Struggle for Market Economy Status - 9th Dec 17
Is Gold Really Strong? - 9th Dec 17
Bitcoin Parabolic Mania - 8th Dec 17
SPX Make a 61.8% Retracement - 8th Dec 17
Gold, Stocks and Bonds - The 3 Amigos Update - 8th Dec 17
Gold Stocks Break, Gold to Follow - 8th Dec 17
4 Charts That Show How Trump Tax Cuts Will Trigger A Recession - 8th Dec 17
Precious Metals Breaking Down! 3 Amigos to Abort? 4 Horsemen to Ride? - 7th Dec 17
Bitcoin Just Smashed Through $12k… Wait, $13k… Now $14k… This Is Getting Ridiculous! - 7th Dec 17
Stock Market Tops Look Like This - 7th Dec 17
Crude Oil, Oil Stocks and Invalidation of Breakouts - 7th Dec 17
Bitcoin Doesn’t Exist – 2 - 7th Dec 17

Market Oracle FREE Newsletter

Traders Workshop

Do Stock Market Investors Really Want The Fed to Lower US Interest Rates?

Stock-Markets / US Stock Markets Sep 06, 2007 - 02:02 PM GMT

By: Hans_Wagner

Stock-Markets Best Financial Markets Analysis ArticleInvestors trying to beat the market are closely following the trends in interest rates, especially the Federal Funds Rates. With many of the market traders and talking heads calling for a cut in the Fed Funds rate, do investors follow their advice or make their own assessment. Let's look at what the theory says about the link of interest rates and the market. Next we will look at the impact of inflation will have on rates and finally a chart that compares Fed Funds rates, the 3 month Treasury Rate and the S&P 500. 


The Theory

In theory changes in interest rates and movements in the stock market move in opposite directions. Assuming investors are rational people, when interest rates decrease should encourage them to move money from the bond market to the stock market, as bonds will be returning less as rates are lower. Also, businesses will be able to borrow at lower rates to finance growth and expansion, which should lead to future growth and as a result higher stock prices.

The other effect a cut in interest rates is psychological. Investors and consumers see lower interest rates a sign that they can borrow more cheaply, meaning they can spend more. This in turn should contribute to higher corporate profits, expansion of the economy and therefore higher stock prices.

The discounted cash flow model is one method used to value securities. This approach takes the sum of all expected future cash flows from a company and discounts them at a capital value rate to derive the current value. To obtain the stock price one takes the sum of future discounted cash flows and divides this value by the number of shares available.

Using this method and investor can compare the return on two investments; let's say a treasury bond and a stock. If the money they get from bonds is less than the money they get from the stock they should buy the stock. On the other hand if the money they get from bonds is greater than the bond then they should buy the bonds.

Basically the higher the interest rate, the lower will be the value and therefore the price of a payment in the future. A rise in the interest rate causes stock prices to fall. And a fall in interest rates causes the price of a stock to rise.

The complete theory is more complex and detailed.

The Reality

According the latest release from the Bureau of Economic Analysis (July 31, 2007) Personal Consumption Expenditures (PCE), supposed to be the Federal Reserve's favorite inflation indicator, was 2.1% for the year. This is just above the rumored Federal Reserve's target inflation range of 1 – 2%. For reference the table below shows the PCE rate for the last eight months. It has been decreasing since May 2007, though it has remained in a 2.1 – 2.6 range. So inflation is not yet within the Fed's desired range, though it is close. 

Price Index for Personal consumption Expenditures: Percent Change from Month One Year Ago

Month Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07 Jul 07
PCE 2.3 2.1 2.3 2.6 2.3 2.4 2.3 2.1

Source: Bureau of Economic Analysis Press release (July 31, 2007)

The August 17, 2007 Point of Interest discussed how the Fed faces a series of difficult months ahead on the inflation front. This seems to imply that the Fed is not yet ready to lower the Fed Funds rate, even if the market says it must have a lower rate. 

Now let's look at what has happened in the past to the market when the Fed has changed the Fed Funds rate. The chart below is a weekly chart of the S&P 500 beginning in 1990 to the present. The top part of the chart shows the US Treasury 30 month bill rate and the Fed Funds rate. The data on the Treasury Bill rate only went back to 1990, so that is where I started the chart. Take a few moments to look over the chart.

A couple of observations. From 1990 to 1993 the theory that when interest rates go down the market goes up worked. In 1994 rates went up, with the Fed Funds rate leading the way and the market was basically flat. The theory worked again. Starting in 1995 rates went sideways to slightly down and the market move up in a very nice bull market. Starting with the middle of 1998 the Federal Funds rate started to climb and the market experience a strong pull back from just below 1200 to the 950 area. Then the market moved up to finish 1999 much higher. Meanwhile Fed Funds rates and the short term 3 month treasury rate climbed. As everyone knows the market peaked in early 2000. Up until then the theory that when rates moved up the market went down held. The rise in rates in 1999 did not result in a corresponding fall in the market until the first half of 2000.

Starting in 2000 interest rates were lowered dramatically to help deal with the economic slow down. The market fell as well, with the 3 month Treasury Bill rate following behind. As shown Federal Fund rates eventually reached the one percent level, where they remained for about a year. In July 2003 the Fed began to raise the Fed Funds rate over the next two years, reaching the current level of 5.25 percent. The market also began its most recent bull market run in early 2003. So in this case the theory did not follow as rates rose and so did the market. But then rates were considered to be to low by many which helped the economy expand, causing the market to rise. In this case the theory did not work.

This leaves us with the question, if the Fed lowers interest rates, will the market go up? According to the theory, the answer is yes. However, what if the reason the Fed lowers rates is because the U.S. economy is perceived to be going into a recession, rather than just slowing down. I suspect if investors realize this is the case, then the market will fall rather than rise. As happened in 2000, when the economy's growth rate was negative the market also fell. Yes, it was at an extremely high level, but an economy that is experiencing negative growth is not conducive to a stock market that is expanding.

If the Federal Reserve does not lower rates on September 18, 2007, investors need to understand why rather than just throw in the towel and give up. They may be seeing cont9inued economic growth and they are still worried about inflation. The economic news so far is mixed with Gross Domestic Product in the second quarter up a revised 4% and retail sales are stronger than expected. The latest Federal Reserve Beige report did not provide sufficient economic data to support a rate cut, causing the market to fall after it was released. However, the housing sector is still falling as credit problems continue and sales of new and existing homes continue to drop.

On Friday, September 7, 2007, the Labor Department reports on jobs and salaries, a key insight into consumer spending, which makes up 70 percent of the U.S. economy. This will be an important indicator, especially if it surprises either to the up side or down side. It will also be important to monitor what the Federal Reserve members say in various speeches before they meet in September.

For more information on the linkage of interest rates and the market check out Economic Growth by David Weil. An easy to read book that presents the key factors to understand global economies. It is expensive and is used as a text book for college students, but it is worth the money.

The Bottom Line

Investors need to be careful as they might get what they wish, a lower Fed Funds rate. While many believe it is good for the stock market, it is also a sign that the economy is weaker than expected, possibly indicating a recession is near. As long as the Fed believes the economy is not slowing too much, then I expect the Fed funds rate to remain at 5.25% until there are clear signs that inflation is under control. Beside the market is already factoring in an interest rate cut. If they get one, it is unlikely to move the markets very much, unless the Fed changes its focus. For now investors need to be very careful as there is more down side risk in the market.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Hans Wagner Archive

© 2005-2018 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

dennis
06 Sep 07, 19:13
Stock Index opening

At the daily opening of the stock market in Hong Kong per say what component is used in deciding a higher or lower index opening and how is this calculated. Please advise. thank you


Shravan Kumar
14 Sep 07, 02:46
Fed interest rates!

I am from India and there is feed back from friends in USA that FED may not only cut the interest rates but there is strong possibilty that FED may increse the rates to 5.50%

Regards.

Shravan Kumar

Jaipur (India)


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife