Wednesday, September 19, 2007

How to Play the Fed Rate Cut

To much fanfare and cheers from Wall Street the Fed cut interest rates by 0.5% yesterday. The markets were virtually certain that the Fed would cut rates, but pundits were arguing whether the cut would be a moderate 0.25% or an aggressive 0.5%. Well, the Fed is trying to signal that it means business and that it will not let the economy sink into recession without a fight.

What does the rate cut mean for the average investor and what is the correct reaction? Frequent readers of this blog know that I am a "steady as she goes" kind of investor. I do not let the ups and downs of the market change my carefully planned investment strategy and asset allocation. Having said this, the rate cut is likely to effect different asset classes in different ways:

1. Money Markets and CD's - even before the cut experts have been talking about the fact that yields on CDs and money market funds were destined to go lower. With the turmoil in the market, many investors were panicking and moving their investments to safer investment vehicles. With more money being thrown into CDs and money market accounts, financial institutions could reduce the yield that they offered.

The rate cut will certainly cause the yields to decline. If not tomorrow, then in the next few weeks. This means that if you are planning to keep a cash position as part of your portfolio, you may want to look into the option of locking some of that money in CD's at the current higher rate.

2. International Investments - with the yield on the Dollar going down, and the international economy still expanding, the chance for a further decline in the Dollar vs. other major currencies has increased. This means that investments denominated in foreign currency will be worth more in Dollars, and that companies that do business abroad or rely on exports to a large degree will be seeing their income increase when converted back into Dollars. If your portfolio is short on foreign investments, now may be a good time to boost that portion of your investments.

3. The Domestic Stock Market - the stock market loves interest rate cuts. The reason? When interest rates go down, the yield on safer investments becomes less attractive and people move into the stock market to find higher returns. With a greater demand for stock, their price climbs. In addition, companies find it easier to borrow money to expand their operations, and find it cheaper to pay their obligations. Both factors tend to support earnings.

Is the bull market coming back with a vengeance? I have no clue, and neither does anyone else. However, if I were a betting man I wouldn't put my money on it quite yet. The economy is not out of the woods. No by a long shot. In fact, I think we may just be starting to walk into them. If that is the case, the stock market is going to see some choppy water before any celebrations can begin. I am guessing volatility will continue at least for several more months.

4. Bonds - Have you gotten tired of seeing the bond portion of your portfolio stagnate for the past several years? I know I have. Many a time I thought about dumping my bonds and doing something productive with the money, but prudence won out. I stuck to my asset allocation plan. Now come the better times for bonds. As yields on the money market drop and as interest rates continue to decline, bonds start to look better and better for those conservative investors that don't want to jump into the stock market. An environment of interest rate cuts is typically one in which bonds show some muscle. That would be nice.

5. Real Estate - remember the woods I mentioned a couple of paragraphs ago? These are the woods I am referring to. The Fed cut interest rates, and that's good. The cut may mitigate some of the pain and save some homeowners from foreclosure. BUT I am not rushing out to buy a house, or to increase my exposure to the real estate market. There are too many darn houses on the market. Those are still there whether or not the Fed cut the rate. Let's face it. We just came through a major real estate bubble and prices have a ways to go before they return to sanity. They can either drop outright, or they can stagnate while inflation catches up. Either way, real estate has had its day in the sun, and I think it will be a while before we return to the crazy day of the flipper.

6. Commodities - the Fed cut is likely to boost economic activity and with more activity comes the need for more raw materials. We have seen crude oil prices break records two days in a row, and I suspect high commodity prices will last. Am I investing in metals, corn futures or oil? Nope, but until economic activity cools down substantially, I think we will continue to see high commodity prices. In fact, I wouldn't be surprised to see commodity prices holding at current prices or higher for years to come.

That's my take on the economy and the likely outcomes of the Fed rate cut. Unfortunately, I am no prognosticator. I wish I had a functioning crystal ball, but lacking one I think I will stick to my tried and true asset allocation strategy. I go through this analysis as an intellectual exercise, but I don't typically act on my own advice. I don't recommend you act on it either.

1 comment:

Pinyo said...

This is a great explanation of how rate cut interacts with various investment options. Thanks!