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Wednesday, September 19, 2007

Rate Cut, So What's Next?

I have to admit I didn't expect the Fed to be so aggressive and lower the Fed rate by 50bp in one cut. The immediate reaction from the market is a broad-based super rally. Here's the press release from Federal Reserve:

"The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth."

What to expect after the rate cut?

1) Dollar will continue to weaken
Intraday action of USD/EUR

2) Metals will continue to rally

It should not be hard for the XAU to hit 170, the previous high in May'06

3)Is the US economy weaker than we think?
By taking a drastic cut of 50bp in the Fed rate, the Fed has fears that the "fundamentally strong" economy may not be able to withstand the housing slump and credit crisis and be eventually lead to recession. If so, then the economy is really not THAT strong isn't it?

Now, take a look at this:
The S&P 500 landed positive 6 months after rate cuts in the last 7 out of 11 times. That is a 63.6% probability.

Schaeffer Research also takes a historic look of the last 4 Fed interest-rate cuts
"In 1989, 1995, and 1998, the market either bottomed or was close to a bottom, which was followed by bullish price action in the subsequent three months. In 2001, the market initially rallied for the first month before reverting back to the primary bear trend."

All this seems to point to the positive, although the last rate cut was not. I hope the Fed cut will really help the economy and prevent a recession.

Finally, in a dated article "Clues to the Fed's rate cut cycles" written during the 2001 rate cuts, it examines the impact of Fed cuts on mortgages, certificates of deposit, auto loans and other products.


Blogger Tony Chai said...

Hi SOT :

Thanks again for an informative article.

The 50 basis point cut in the Feds Funds Rate is certainly a great relief to the market amidst its recent woes of sub-prime mortgage meltdown & credit crunch, not forgetting the withdrawal issues recently faced by Northern Rocks.

The rally is most probably going to carry on today. Even Lehman Brother's (LEH) earnings was not that badly hit and went up almost +$6.00 to $64.49.

Yours Truly,

Tony Chai
My Options Trading Blog

3:51 PM  
Blogger Simply Options Trader said...

Hi Tony,
It is indeed a relief to the market, but it can be a double edge sword...

With the huge burst of strength yesterday and looking at the chart, I don't expect much rally to go on today unless we have very good economic data coming out. But I could be wrong :)

5:41 PM  

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