Wednesday, October 25, 2006
Fed to decide on rates tomorrow
The Federal Reserve can, in one decision, decide the fate of the US Economy for an entire month. Each month the Fed comes together to discuss the prime rate, or the interest rate charged to banks for wholesales loans.
Lowering rates means that businesses can borrow more for less and expand and break-neck paces but also creates high inflation. High rates cause the market to slow down, businesses stop borrowing as much to keep interest expenses down.
No decision has a greater effect on the economy and the financial markets as the rate decision. When rates are high, it brings in money from all around the world to our interbanks where other countries can earn on our high yields. But domestically high rates are known killers to the markets.
Under Greenspan, the Fed was often criticized for lowering rates too low and causing inflation then bringing the prime rate too high and causing an economic fall out.
Last year the Fed seemed rather concerned about sky high housing prices in California. Raising interest rates curbed people from moving every six months and making hundreds of thousands of dollars from the leverage obtained from low interest rates. People could borrow for 4-5% and make 30-40% on the total price of the home. Often, homes would go from $500k to $1M in less than a year and pocket the home owner $500,000 minus interest of roughly $50K.
Investing with borrowed money in real estate gives extreme rates of return. Most lenders require only 5% down payment if they even require one at all. An investor could take control of a $1M home for $50k and in one year sell the home for $1.2M, a gain of $150k and a percentage gain of 200%!
These market conditions cannot be sustained forever, if they did, bread would cost $10 a loaf and milk $30 a gallon. This creates an economic divide. The poor work for low wages while the rich investor can double his money every year. We’ve seen in the past that this is never a good thing for a nation. (French revolution)
The Fed plays a very important role in the economy that is often overlooked. The interest rates bring new investments from overseas into the markets and help inflate returns domestic investors can earn.
The Fed is even more important internationally than in the US Equity markets. The forex market is a $1.9 Trillion a day market. All of the largest banks participate on the foreign exchange. To keep it simple, the foreign exchange markets are the backbone of the global economy.
Start watching the Fed reports and the rate meetings. There is a lot to be learned about how the Fed dictates the prime rate and what effect is has on not only our investments but investments around the world. Look at all the previous stock market crashes, especially 1987 and see what the Fed had to do with it. Prime rates affect more than just how much your house or car cost you each month as they can effect your retirement seemingly overnight.
I think rates will stay the same at this next meeting. The market is moving at a good pace and it’s too early to try to stop it. If the Dow starts to approach 12500 I think we will start to see some pressure to raise rates.