The Great Fed Rate Cutting Myth: Look Out Below

This Tuesday the FOMC will meet to consider another cut in Interest Rates. After recent hints from various Fed Governors, and Bernake himself, a Rate cut almost seems assured, and many people even expect a 50 basis point cut.

We have already detailed the risks associated with this so the debate is clear. However, as clever as the inflation concerns sound, the current FOMC seems to find priority in the current economic conditions rather than inflationary pressures (maybe rightfully so).

Right or wrong, Wall Street is embracing the Fed's action, yet again. This leads us to one of the biggest jokes on Wall Street.

Institutions take quiet pride at 'sticking it to the little guys'; they even like to stick it to their peers. Executives will never tell you this, but you can imagine the management from Goldman Sachs (GS) sitting down to a hearty Steak Dinner, and patting themselves on the back for trading their way out of the Subprime Mortgage mess, for example, while leaving everyone else to hold the bag.

The high level executives at these major financial institutions, usually, know the Market better than anyone else. If nothing more, they know the broader trends for sure. The recent turn in Oil for example was obviously cyclical, yet there were still people fighting the cyclical trend when institutions were selling into the strength.

On a broader scale this also happens with Interest Rates.

When the FOMC cuts interest rates they are doing so because the economy is weak, and likely to get weaker; they see major risk on the horizon. Institutional players know this and Institutional Players know the Market reacts negatively to adverse economic conditions, so when the Markets increase on the heels of, or in advance of a rate cut, Institutions usually sell or short into those rallies. The same thing happens when the markets decline due to a rate increase; they buy the dips, when everyone else is doing the exact opposite.

Take a look at the two charts below and notice the correlation. In 1997 the FOMC started offering a Target Fed Funds Rate, and since then the Market has trended up when Interest Rates were trending higher, and the Market has declined when interest rates were being cut.

click to enlarge

The joke is... No one on Wall Street gets it! Wall Street players keep buying the Market when rates are cut, but they shouldn't be. Hopefully they are just trading, and passing the buck along to the little guy (typical). That won't be you though if you are reading this, and if you see the correlations the charts above prove.

When the FOMC cuts Interest Rates, if you ask any layman he would probably say that the Fed is cutting rates because the economy is weak, and the Stock Market might very well be under pressure accordingly. But ask anyone on Wall Street, other than your Tier One Executive, and he's likely to tell you that a cut in Rates will spur the Market higher. The charts above argue the opposite.

The Market follows the trend of Interest Rates.

The Stocks most likely to be affected by a cut in rates initially are usually those same top tier financial stocks whose executives condone selling or shorting into blips higher when rate cuts are announced. Coincidentally these financial stocks are usually the same ones hurt most by continued deterioration in the economy too.

Comments

[PJ568]

IMO, all I see is flawed logic and charts that don't support the conclusion that "the Market follows the trend of Interest Rates".

[ikkeme]

I think you're right. The street insiders herald every rate cut as a buying oppotunity, then they sell into it because they know that it will eventually go lower, and the rate cut is an opportunity to unload their positions into a retail-based rally

[john haskell]

1. Please identify "those same top tier financial stocks whose executives condone selling or shorting into blips higher when rate cuts are announced." Does Goldman (characterized as "sitting down to a hearty Steak Dinner" (sic)) condone selling into blips? Are they shorting their own shares or shares in general? Should I sell shares in GS or not?

2. A ten year chart showing a very general trend between two variables doesn't prove anything. Further, interest rates certainly increased in 1994- did the Dow? No.

3. Capitalizing Every Noun You Use in your Article Does Not Make it More Authoritative. It Just Makes It Harder to Read.

[flow5]

Reserve requirements in the U.S. are no longer binding.

[hillcrestln]

You didn't go back far enough. At federalreserve.gov, click on monetary policy and check the table titled "Intended Federal Funds Rate." From July 95 to Jan 96, the Fed cut rates three times by a total of three-quarters of a point to 5.25. The cuts sustained one of the great bull markets in history. Current P/Es are more like 1995 than 2000. Whether we will remain recession-free, as in 1995 but not 2001, remains to be seen.

[bgmaster]

I looked up this phenomenon this fall when the Fed got ready for the first rate cut, because I remembered the last time the Fed STARTED to cut rates (after a series of hikes) the market slumped after an initial pop up. As I recall, I found that the market got to about 12% LOWER within a couple of months after the first cut.

I wasn't sure the idea held true on subsequent rate cuts, but this graph DOES seem to show that.

I think the reason this has been happening in recent years, and perhaps did not in the mid 90's, for example, is that the fed has been CHASING the economy (up and down) lately, but perhaps was on top of it (or ahead?) in earlier times.

Anyway, with the market toppy this year I avoid investing money from a May house sale in stocks, and sold more after the first rate cut--and so far I'm still glad I did.

[User 24147]

Looks to me though if you wait for interest rates to start climbing again you would have missed the great gains of 2003. I think there to be a little more to it than just two simplistic variables.

[Thomas Kee]

I won't comment on all posts here, but in general...

The Fed did not start the Target Rate until 1997. This analysis stems from the beginning of the Fed offering a target rate.

Since then there are disctinct correlations. The above charts show that. They need not be exact, but they are good indicators, that's the point. If you can identify the turning points in the Fed Funds rate you can usually do the same in the Market.

[Pangaea]

hillcrestln -

I could be wrong, but I don't think the current U.S. condition and structural issues are very comparable to 1995/1996...