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Are The Feds Happy With Their Decision?

Author: Ravi Prakash (info)
Website: http://www.optionstradinglessons.com/
Posted: September 24th, 2007 at 7:52 am EST
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The Market got its wish for a 0.50% drop in the Fed Funds rate and as a bonus the Discount Rate got the same cut too. I was somewhat surprised by the big cut as I expected them to be fearful of what that might do to the US Dollar and the Bond Market. The US Dollar did fall and I expect it to fall some more in the near future. I was also shocked to see that the US Dollar actually dipped briefly below 1 against the Canadian Dollar. I started taking notes on how the drop affected other Market factors and more importantly what affect it had upon mortgage rates and the sub-prime Markets.

The first thing I noted was Oil and Gold shot up along with some other commodities. At the same time the US Dollar took a dive against the Euro, Yen and other currencies. And oh yes the major Stock Market Indices shot up. Maybe even Market perception has changed to a positive bias towards the US economy. However I did notice that although the DOW is a stone’s throw away from its 14,000 highs, not all stocks are back to where they were the last time the DOW was at this level.

Next I put myself in the shoes of an Oil exporter. If I used to be able to sell 900 barrels of Oil to buy myself a brand new luxury car and then suddenly due to the fall in value of the US Dollar, I now have to sell 1000 barrels to buy the same car, what would I do? Take the loss? No way (I am a capitalist). The easiest thing for me to do is increase the price of my oil, so 900 barrels will continue to get me my new fancy car. In the case of Oil exporting countries the same thing applies. They can either raise their prices or consider selling their oil in a stronger currency. (See my past article about oil and currencies.) There is always a slight danger for foreign countries who remain linked to the falling US Dollar, that they will import any associated inflation as well. Those that have linked their currencies to the US Dollar (Saudi-Arabia), are probably reconsidering that decision.

I also thought about what a cheaper Dollar will do for US exporters. Well it is clear that their products and services are going to be much cheaper for foreign buyers. That could potentially increase our exports, assuming there is a demand for our goods and services. What about China who long ago linked the Yuan to the US Dollar. They have been under pressure from the US Government to stop the link and let the Yuan appreciate. If they choose to do that their goods are going to become a little more expensive (i.e. our prices will rise at Walmart). That may result in a positive potential outcome where U.S. consumers buy less Chinese goods, thus decreasing the U.S. trade imbalance with China. A negative outcome brought about by a weakened Dollar against the Yuan, would be that China decides that they no longer wish to fund our spending habit by buying our debt, and thus decrease the amount of bonds they purchase. That would be bad for the U.S. economy as we would have less buyers for our debt and continue to “run up the tab” by buying even more on credit. All of that would eventually lead to higher interest rates.

Finally something close to home; Real Estate and Mortgage Markets. How did the drop in rates affect them? Believe it or not the long term mortgage rates did not budge at all. In fact they went up a wee bit. I thought that part of the reason the Feds dropped rates was so home owners could refinance at cheaper rates and keep their homes. What the increase in long term yields say to me is that lenders have not changed their opinion about their perceived risk of lending. If anything they expect more inflation in the coming years. They are reflecting the reality that the Fed is not talking about. Lowering rates short term does nothing to fix the actual issues and in fact makes it more likely that rates will rise in the long term.

According to statistics on the web it seems a huge amount of ARMs are coming due for a re-adjustment in the next 3 months. Assume that a fair percentage of them fall into the “sub-prime” category. I also think that home values are going to remain weak or go down in many parts of the country (Mr. Greenspan agrees with me on this). That will continue to add to the misery of home owners who bought at the top of the market. So regardless of the good intentions of the Feds, I fear many are going to lose their homes. I also suspect we are going to be seeing more mortgage foreclosures in the coming year. Will all of this force the Feds to cut interest rates further? More importantly will it help anyone?

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