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Tomorrow, December 12th, 2006, the Federal Open Market Committee’s Policy Statement is due to be released. The financial community is virtually unanimous in its belief that the FOMC will leave the interest rate untouched. Stock market investors, however, are hopeful that the press release will give some clue that interest rates may soon come down. The market has already priced in a quarter-point interest rate drop by early spring of next year. While it is certainly possible that interest rates will indeed begin to come down next year, I am doubtful that this scenario will play out without a significant downturn in the economy. In short, my position is that the Fed will not begin to lower rates unless there is real fear of an imminent recession.



The lowering of short-term interest rates would lead to downward pressure on the following markets:


1. The U.S. dollar

2. Bonds


It would lead to upward pressure on the following:


1. Real Estate

2. Gold

3. Petroleum

4. Equities (at least initially)



A rate cut would also exert upward pressure on inflation and the GDP, and would encourage foreign investors to remove capital from investments in the United States.



The only positive results, from the Fed’s perspective, would be the upward pressure on residential Real Estate, Equities, and GDP. The equities markets, however, are in good shape and are not in need of a “lift”. Most of the major averages are up handsomely on the year and the Dow is near an all-time high. As for Real Estate, most market gurus believe that we are at or near a market bottom, and that as builders’ inventories decrease, the market will slowly begin to recover. In addition, I believe it to be highly unlikely that the Fed wishes to reignite the real-estate bubble now that it seems to be deflating in an orderly manner. I also believe that the Fed does not want to fuel GDP growth at this time. They want a soft landing and are still more concerned with inflation than they are with slowing growth.

The possible negative implications of a rate cut are numerous. Petroleum and other commodities would rise as the dollar weakens, causing inflationary pressures. I believe that we are now only one oil-price runup away from 5% inflation, which would be bad for the economy and devastating to the Equities markets.


The economy does not seem to be exhibiting strong signs of a pending recession. Employment is high, wages are up, and consumer spending is not too bad. There is really no reason for the Fed to begin thinking of cutting rates. Also, there is one governor who still votes for a quarter-point rise in rates at each meeting. To hint at a rate-cut in the policy statement would divide the Fed effectively into three camps, and make Bernanke seem like he is not in control.



A rate cut would also expose the Fed to potential embarrassment. Suppose the Fed hints that it may cut rates. This would then drive up petroleum and other commodities and weaken the dollar, leading to inflationary pressures. If the situation seemed to be getting out of control, then the Fed would be forced to reverse course and continue the trend toward rising rates. The Governors are well aware of these risks and do not want to look like fools.


Conclusion: The Fed will not hint at a rate cut. They will not cut rates until they are forced to by the real threat of a recession. This leaves us with one of two scenarios, either a recession is coming or it isn’t. If a recession is not coming, then rates will stay where they are and the stock market will correct until investors lose hope of a rate cut coming anytime soon. If a recession is coming, then earnings forecasts will come down and the stock market will correct accordingly. In either case, the result is bad for the stock market.


I am going short equities. The only long positions that I will continue to hold are commodity-based because I believe that we are in the midst of a secular commodities bull market. I will also continue to hold some value stocks that are trading near book-value and/or have very low P/E multiples.


I am shorting mostly components of the ETF's (SWH, IAH, IIH, VCR) that have have the highest returns over the past 3-6 months because I believe that these stand to correct the most.

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