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Asset Class Behavior Following Fed Rate Cuts

"The dollar has been sliding since the Fed last week cut interest rates by a larger-than-expected half percentage point. Since then, disappointing U.S. economic data have stoked expectations that another rate cut is on the way. Lower interest rates, used to jump-start an economy, can weaken a currency as investors transfer funds to countries where their deposits and fixed-income investments bring higher returns.As the dollar sinks, consumers find imported products -- Australian wines, Japanese cars or Chinese toys -- are more expensive."

Associated Press -09/28/2007

 

Purchasing Power is of Primary Importance

Since our money is only as valuable as what it can buy for us, a well thought out investment strategy should always strike a balance between preservation of capital and preservation of purchasing power. On the one hand, an approach which is too conservative can leave an investor wondering how their standard of living seems to be going backward even though their CDs are earning interest. On the other hand, an overly aggressive approach can lead to sleepless nights and large losses, from which it is difficult to recover. We will attempt to show why in the age of credit expansion it may be more important than ever to approach investing from both ends of the risk spectrum. As a money manager and financial advisor, my task is similar to a cardiologist who instructs his patients to remain active after a heart attack while at the same time avoiding too much stress on their recently damaged hearts. If the patient becomes too sedentary, it can be costly. If the patient adopts an overly ambitious exercise regimen it can also be harmful. Balance is the key.

Perception Is Reality

With the Federal Reserve (Fed) somewhat surprising Wall Street with a .50% reduction in interest rates, we have officially moved from a cycle of increasing rates (June 2004 - June 2006), to a cycle of flat rates (July 2006 - August 2007), to a cycle of declining rates (September 2007 - ?). While the actual impact the Fed has on market interest rates has diminished over time, Wall Street's perception is the Fed still matters a great deal. What matters to us is the new Fed cycle will influence investors' actions, and thus influence the relative returns of different asset classes such stocks, bonds, commodities, timber and commercial real estate.

Why Did The Fed Lower Rates?

Wall Street has been packaging more and more complex investments over the years, such as bundling traditional mortgages with sub-prime mortgages and selling a stake in the form of a bond. Investors, including large institutions and hedge funds, have purchased portions of these mortgage pools after being told the diversified mix of mortgages minimizes their risk. Everything looks fine until someone stops paying somewhere along the food chain, and matters become even worse when several parties simultaneously stop paying. The ever increasing complexity of these derivative investment vehicles has caused participants to question how much risk they are really exposed to. The complexity also creates uncertainty as to the future need for capital in the event more defaults occur. Another problem tied to the complex and uncertain nature of these investments is a growing mistrust between counterparties. Since many banks, institutions, and hedge funds do not know what the future may hold, the tendency is to hold onto your cash until the smoke clears. According to the Economist, "it could take months to put prices on these complicated mix of investments". As a result, the availability of credit has diminished in recent weeks. Obviously, tighter credit conditions are the last thing a housing market on the ropes needs. The Fed knows a significant portion of our economic growth since 2000 has been fueled by low interest rates, easy access to credit, and rising home values. They lowered interest rates in an effort to slow the negative momentum.

The Weakening Dollar: Fed's Actions Have Consequences

Lower interest rates lead to lower borrowing costs, which increases the demand for loans and access to credit. In the fractional banking system, new loans create new money which increases (or inflates) the money supply and reduces the purchasing power of the dollars we currently hold. More money chasing a relatively stable amount of goods and services can lead to "bad" price inflation. Monetary inflation can also lead to rising prices in stocks or real estate or "good" inflation. Newly created money also devalues the money in your pocket via simple supply and demand. Therefore, the terms inflation, a declining U.S. dollar, currency debasement, etc. all refer to an expanding money supply. A hedge against inflation is also a hedge against the declining value of any paper or fiat currency. Credit creation and money supply expansion are not limited to the United States; we just may be the leader in terms of being addicted to credit. I have written on theses topics in the past with the most relevant articles being:

The U.S. Dollar vs. Gold: You Should Care

Investing In Today's Inflationary World

What Can We Learn From 1923 Germany?

How to Protect Yourself from Investment Losses and Inflation

A Better Read on the Bernanke Fed

Wall Street coined the term "Greenspan put" to describe the former Fed chairman's willingness to quickly lower interest rates during periods of "instability", which is a politically correct way of describing a period when risk takers are suffering large losses. A put contract is like an insurance policy which covers or offsets investment losses. Therefore, the Greenspan put referred to the confidence risk takers had in Mr. Greenspan's willingness to protect them with rate cuts in declining asset markets. It is similar to a teenager who may feel they can take more behavioral risks knowing their parents would ride to the rescue in their time of need. As you might imagine, the Greenspan put helped increase the risk tolerance of many investors, which in turn helped fuel bubbles in tech stocks and housing. The Greenspan put was a two-pronged bubble blower. Individuals and institutions could invest money borrowed at lower rates. As an added bonus, investors also got an insurance policy against being hurt too badly in declining asset markets.

With a new sheriff in town, Chairman Bernanke, the investment community was concerned the days of the Fed riding to the rescue when risky investments began to sour may be over. As discussed above, lower interest rates help fuel both monetary and price inflation. Therefore, the Fed's inflation-fighting credibility is at risk when the institution appears to mirror the Greenspan Fed. Anyone who has followed Bernanke's career was not surprised when the Fed recently sent a loud message indicating the Greenspan put is alive and well. In fact, we may see a turbo-charged Bernanke put in the form of faster and larger cuts. In a well-written article by Mike Swanson (wallstreetwindow.com), he states:

Bernanke built his career on a doctoral thesis that claimed the Fed didn't cut rates fast enough during the 1929 stock market crash. What Bernanke believes is the Fed should have cut rates all at once during the start of the bear market instead of gradually over two years. He seems to be putting this belief to work right now.

PART II of IV

PART I
PART III Coming Soon
PART IV Coming Soon

 

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