The Great Fed Rate Cutting Myth: Look Out Below

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 |  Includes: DIA, IAI, IEF, IYF, QQQ, SPY
by: Stock Traders Daily

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 (NYSE: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.