Many years ago, before transparency and communication skills mattered to the Federal Reserve, the central bank often was most effective when it surprised us with its interest rate moves.
Tuesday’s half-point interest rate cut, to 4.75 percent, had that old-time feel. The stock market staged its biggest one-day rally in more than four years, with the Dow Jones industrial average surging nearly 336 points, oil and gold prices jumped to record highs and the dollar sank to a record low against the euro.
How’s that for keeping nervous markets steady?
“I was only attributing about a 5 percent probability to this,” said Michael Woolfolk, senior currency strategist at the Bank of New York Mellon.
In the main, analysts cheered the Fed’s move as an appropriate assist to the U.S. economy and a validation of the Fed’s relevance in a financial world increasingly dominated by private-sector traders and secretive hedge funds.
The Fed cut the so-called federal funds rate on overnight loans between banks and the discount rate charged to banks for emergency loans from the Fed, both by half a point.
“The decision that was made today was that the risks to the broader economy outweighed the risk of bailing out those who had not properly managed risk,” Woolfolk said. “I see this as a very positive development for the equity market and the U.S. economy.”
But the Fed’s action was just the first round in the title match between central banks and private-sector lenders that have seen their profits and balance sheets squeezed in recent weeks by the restive buyers of their credit-based securities.
“The banks are happy, because this [Fed rate cut] just cut their funding costs,” said Joseph Trevisani, chief market analyst at FX Solutions. “It’s the banks that are holding back the money. They don’t seem to know what’s coming down the pipe to hit their books.”
Meanwhile, consumers can hope for greater access to credit at lower costs.
“Do you borrow at the [federal] funds rate? I don’t borrow at the funds rate,” said Jim Bianco of Bianco Research. “We borrow at market-based rates. You watch a parade of experts talking about how this will bring relief to homeowners and other borrowers. This will only bring relief if market rates go down.”
A long-standing rule of thumb for investors is “Don’t fight the Fed.” That is, when the Federal Reserve goes on a campaign to reduce short-term interest rates, long-term interest rates generally follow the same path. The rule could apply again, but the jury is still out. Thirty-year Treasury bond yields increased after the Fed announcement.
Libor rates key indicator
In recent years, interest rates on long-term loans, such as mortgages, have been more closely linked to short-term market rates, such as three- and six-month loans pegged to the London interbank offered rate, or Libor.
Normally, Libor rates track closely with the federal funds rates. But in recent weeks, Libor rates ballooned, reflecting the global credit squeeze. The movement of Libor rates beginning Wednesday morning will be a key indicator of whether Tuesday’s Fed action calmed financial markets.
Certain credit benchmarks, such as yields on junk bonds, eased late Tuesday, reflecting the stock market rally’s boost to corporate financial strength.
But “the most important market-based rate in the world is Libor,” said Bianco. “When the Fed lowers interest rates and market-based rates don’t follow, that is the prime definition of a credit crunch. If Libor rates zoom down, that would mark the end of the credit crisis.”
Otherwise, fears will emerge that the Fed is simply replacing a deflating bubble in house prices with an inflating bubble in U.S. stocks or other financial assets, Bianco said.
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Another concern that will play out in the days and weeks ahead is inflation. In response to the Fed’s action Tuesday, commodity prices surged.
Crude oil futures reached a fresh record high, $81.51 a barrel in New York futures trading after hitting the day’s high of $82.38. December gold futures jumped to $735.50 an ounce before ending the session at $723.70.
Woolfolk said it’s too soon to say the inflation genie is out of the bottle but not too soon to say the dollar was hit by the Fed’s rate cut. Oil and gold are priced everywhere in dollars, so a weaker dollar generally means higher oil and gold prices.
At the end of trading Tuesday, the U.S. dollar was near the 140-euro mark, considered a major psychological threshold of dollar weakness, and within 2 cents of parity with the Canadian dollar.
“We’re looking for near-term weakness in the dollar,” Woolfolk said.
“Nothing here is good for the dollar,” agreed Trevisani. The European Central Bank has given no indication it will follow the Fed with a rate cut, he noted.
Going forward, the critical factors will be found in the behavior of the U.S. consumer, Trevisani said.
As traders and analysts debate the next Fed move, probably to be determined at a policy meeting Oct. 31, the key data to watch will be reports relating to jobs, consumer spending and consumer confidence, he said.
“We have another bout of statistical navel-gazing ahead of us,” Trevisani said.
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