Are Interest Rates Finally Working?

There is an old saying in Wall Street, “Don’t fight the Fed.”  The Federal Reserve, with its ability to set interest rates, has a huge effect on the economy.  If they lower interest rates they can turn a sluggish economy into one running at full speed.  Likewise, by raising rates they can pop speculative bubbles and bring about a recession (see 2000 and 2007).  It is therefore unwise to be buying when interest rates are rising or to sell short when rates are being lowered.  The effect is so great that the plans of the Federal Reserve are kept secret to avoid moving the market.

Because bond interest rates and the returns of other investments are effectively indexed off of bank account rates and the prime rates, lowering rates makes stock prices go up.  Lowering interest rates also make the cost of borrowing money, which means it is easier for companies to borrow money to finance new projects and expand, thereby making higher earnings.  Lower interest rates also lower rates on home mortgages and credit cards (a little bit), so people might also be able to spend more.  This tends to make the economy grow.  Because stocks tend to lead the economy (remember that people buy stocks based on what they think a company will earn, not what it is currently earning) the first thing that tends to happen when the Fed lowers interest rates is that stocks tend to go up. 

It is common for the stock market to go up long before the rest of the economy gets into high gear.  On the other side, when the Fed starts to raise rates, the stock market tends to fall before the economy starts to slow.  One can think of it therefore as a control system where there is a 6 month to 1 year delay between the time the Federal Reserve takes an action and the economy starts to respond.  This delay causes some people incorrectly think that higher interest rates cause a better economy and vice versa because the Fed tends to raise rates when the economy is doing well (to quell inflation) and lower them when it is doing poorly (to spark the economy).  If you plot interest rates against the GDP, therefore, you will see that interest rates tend to be high when GDP is growing and vice-versa.

In the recent recession, things were so overblown during the real estate bubble, and there was so much uncertainty caused by the doom and gloom projections and the unprecedented government action that the market did not respond when the Fed lowered rates essentially to zero.  It looked as if we might see the same thing as Japan during the “lost decade” in which interest rates were low but the economy remained in the doldrums.  While I’m not yet convinced we’re ready to head higher, things are looking better with the recent rally.  Uncertainty remains with the possible passage of Cap and Trade and the upcoming expiration of the Bush tax cuts, either of which could cripple the economy.  The reaction of the market to the Financial Reform Bill was also not encouraging.

So, what to do?  As always, it is very difficult to accurately predict the near-term.  We might start to take off due to the low interest rates, or we might remain mired in a bear market as economy-killing legislation is passed.  One must always look at the long-term, however, and continue to buy regularly, taking advantage of the lower prices to build up positions.  Eventually things will turn, or the whole economy will collapse and it won’t matter anyway.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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