Dirty Little Secret: Fed Cuts Don't Really Matter

 |  Includes: CAF, CHN, EWH, EWM, FXI, INP, PGJ, SDS, SH
by: Enzio von Pfeil

At the risk of sounding naive, we question the received market wisdom that "when Fed Funds are cut, markets rise." Don't get me wrong: we are not blind, either. Markets are welcoming recent Fed Funds reductions. But, if punters are buying only because of lower Fed Funds, beware... history has a nasty habit of repeating itself.

1. Do markets rise only when Fed Funds are cut?

The market statement that "markets rise when the Fed Funds ("FF") are cut" is misleading. It implies that markets must fall when FF are hiked. Our examination of the data repudiates this claim. Markets behave irrespective of the direction of the FF rates! "Things" are perhaps not so "different" this time.

In order to arrive at this philistine conclusion, we examined FF cycles since 1981, i.e. going back more than 25 years. Our findings boil down to the following:

1. Since June 1981, there have been five FF "cut" cycles and five "hike" cycles;
2. The average FF CUT has been six percentage points;
3. The average gain on the S&P 500 ("S&P") during the five "cut" cycles has been 131 points;
4. Every one percentage point cut in FF has boosted the S&P by 22 points;
5. The average FF HIKE has been three percentage points;
6. The average gain on the S&P has been during the five "hike" cycles has been 93 points, and
7. Every one percentage point hike in FF has boosted the S&P by 29 points.

For our purposes, points 3 and 4 need to be compared to points 6 and 7. Evidently, the market has risen both during FF cuts as well as during FF hikes!

The Economic Clock™ helps to explain why FF are not so relevant from a strategic perspective. Liquidity and earnings are far more important than interest rates. This goes to say that an excess demand for goods boosts earnings - and also the potential for higher inflation. Thus, FF are hiked when earnings rise, and it is the stronger earnings that propel the market upwards. All the more so if there is an excess supply of money, as we have now.

The conclusion is simple: see beyond the haze of lower FF as being "real" market boosters. They are not. An excess supply of money is what is boosting markets, not an interest rate cut of under one percentage point!

Our market concerns remain, however. The reason that the Fed is cutting FF is precisely because it is worried about US growth prospects: The Economic Time™ has been deteriorating in America for exactly one year, so we are baffled as to how domestically-driven profits can rise if turnover and margins are wilting.

2. Pattern predictions of Fed Funds cycles

  • "Hike" cycles last about 23 months and result in a three percentage point hike in FF, and
  • "Cut" cycles last about 35 months and result in a six percentage point cut in FF

So our pattern prediction is that Fed Funds will be on a downward trajectory for the next two - four years, say until late 2009. We reiterate: FF are cut when the economic and thus profits outlook is worsening, and history is repeating itself here. Otherwise, why would the Fed cut rates?

Our hunch, so often repeated, is that the U.S. is going to experience stagflation next year.

3. How to Make Money Off This Idea

1. Always consult your financial adviser before doing anything.
2. We suggest "put" ETFs or options on the US markets.
3. Position yourself for a crash.
4. Keep going after commodities.
5. Focus instead on China (and thus Hong Kong) India and Malaysia: The Economic Time™ there is just fine.