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First with Financial Comment from Arabia

Fed rate decision the catalyst for a market crash?

with 5 comments

The announcement of a policy tightening by the Federal Reserve last week is most probably the catalyst that will bring the long bear market rally to an end. In the most basic of terms higher interest rates make it less attractive to take the risk of owning stocks.

The transmission mechanism is highly complicated and open to considerable dispute by economists. But this only tends to obscure the most obvious, simple and historically true conclusion.

Overvaluation

Besides stocks are way over-valued on any measure – just refer to the recent writings of Bob Prechter for the full details. What you do have to ask is why the Fed would want to do this.

The most immediate reason must be to make future US bond sales more attractive, after recent flops, and also would not a stock market correction be very useful in reigniting interest in bond purchases in any case?

It is not an easy call for the Fed. Keep policy too loose and easy money will carry on bidding up equity prices so far out of line with intrinsic value that the future crash will be even bigger. Pull out too much, too quickly and this is a pack of cards.

Yet that is what it probably is already. Mitsui Bank in Japan called the decision a historic mistake. The Fed is likely setting off a domino effect in the Far East where the dollar carry trade has done the most to bid up asset prices. The unwinding of the dollar carry trade will have the reverse effect.

Dollar carry trade

It was certainly notable that the biggest stock market impact was felt in the Far East last Friday. Wall Street seemed temporarily struck by the notion that this might indicate a stronger economic recovery than previously thought.

However, even the most cursory glance at stock market history suggests this is wishful thinking. Valuations top out with rates at a low point in the cycle and high interest rates are just not good for equities.

Anybody can tell that once tightening starts then the writing is on the wall for even higher interest rates. But the wake up call from the East will be the one to watch.

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Written by Peter Cooper

February 21, 2010 at 10:20 am

5 Responses

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  1. It looks like they took the rate hike with ease as markets brushed off the hike and rallied after the dip. Asian markets today are very bullish as well. Year of the Tiger reminds me of Rocky’s Eye of The Tiger fight back lol..

    Copper is really up today as demand for copper in China after Chinese New Years is coming back from manufacturers. I bought a short position in SPXU last week and caught in this recent rally so I am down on my SPXU shares so I am hoping for a crash but I got a strong feeling that the DOW will go to 10800 in the near term.

    In Dubai on the other hand they are dumping shares and are taking advantage of OIL prices where people are buying while they are dumping because they know of the upcoming default. That $.60 on the Dollar payment after 7 years is pretty shabby. Add that to the problems from Greece and we could see another correction unless governments brush this off and use stimulus cash to prop up markets regardless of what reality is.

    I have noticed recently that when ever short positions rise the market climbs. Even a blind idiot can see that market manipulation is taking place in the US. All one has to do is open up Etrade and look at the options list for calls and puts for ETF’s and VIX.

    Andy

    February 22, 2010 at 12:48 pm

  2. Yes, but not the discount rate, that is pure political phoniness. If the fed funds rate changes we might see a little drifting down of equities but I don’t see that until mid 2011.

    Edna R. Rider

    February 22, 2010 at 5:54 am

  3. I believe the growing debt crisis in Greece may likely be a much bigger factor in stock market volatility as we move forward. Why do I say this?

    New Greek Bond Auctions:
    Primarily because Greece must roll over a fresh 16.7 billion Euro bond issue between March-May 2010.

    Since it takes a month or two to plan for these auctions, and since Greece has never been straightforward regarding its financial situation, I suspect that they will require more financing than they’ve initially indicated.

    Rates, therefore, will rise quickly in Euro-land; rates in the US can’t be maintained at near zero, if the US is ever to have a successful Treasury bond issue this year.

    The bond market itself has the ultimate power here, and Sovereign nations need to respect it accordingly; if they fail to do so, they proceed at their own peril.

    obewon

    February 22, 2010 at 5:45 am

  4. While I don’t dispute much of what you’ve said, Peter, we need to make a clear distinction between the Discount Rate and the Fed Funds Rate.

    The FED raised the Discount Rate, which is the bank borrowing rate. Admittedly, if you go back to the historical pattern over the past 7 or 8 years, the discount rate has alway been higher, and an increase here has been followed, within a period of a few months, by an increase in the FED funds rate.

    While the FED’s decision last week does nothing to improve the appeal of the Treasury bonds in the immediate future, I suspect, as you do, that the FED knows it is in a real tough spot, especially when you consider the TWO failed Treasury auctions over the past week or so.

    So yeah, it’s likely that the FED will raise the FED funds rate within the next six weeks, but the increase will be very minimal.

    Most importantly, the FED’s decision last week is a psychological one, as far as the markets are concerned. “At the end of the day”, the FED is gonna have to raise the FED funds rate a few times (by a measly quarter of a point each time!), and that spells trouble for the overall stock markets.

    Heeding the advanced warning, the wise investor will start to lighten up on their longs, and start to short.

    obewon

    February 22, 2010 at 5:34 am

  5. This is just the Fed blowing smoke in the market’s face. Nobody uses the discount window. The Fed is using the high unemployment rate as cover for keeping ZIRP in place.

    The tell here is the FF futures pricing in multiple rate hikes, this market has repeatedly hallucinated about imminent rate hikes. Remember the three rate hikes which got priced in when FF was at 2%?

    A more likely scenario is that the Fed keeps inflating until people realize this is bad for equities a la the 1970’s. We already had the big crash in equities, there is no reason to believe another one is preordained.

    Theodore

    February 22, 2010 at 1:18 am


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