Fed Policy and Interest Rates

More so than any other institution, when the Federal Reserve speaks, traders listen.  The Federal Reserve is singlehandedly one of the most important market actors, and its monthly meeting minutes make or break many investors.

The Fed and Interest Rates

The most important job of the Federal Reserve is to set monetary policy primarily through increases or reductions in interest rates.  The Federal Reserve has what is called the discount rate, or the rate at which the Fed will lend to other commercial banks.

The discount rate has an immense impact on both the availability of credit and the direction of the economy.  When the Fed moves to increase the discount rate, yields on a variety of fixed income investments from Treasuries to corporate debt rise in response.  Likewise, when the Fed lowers interest rates, yields on debt drop in response.

Why the Fed and Interest Rates Matter

Interest rates are one of the most important ways the Federal Reserve can speed up or slow down economic growth.  Low interest rates, as were promoted by Alan Greenspan in the 1990s and early 2000s, were used to stimulate borrowing and investment.  Since the discount rate at the Federal Reserve was kept so low, corporations and individuals could borrow more cheaply, or simply borrow more.  The result was that people borrowed more money at lower and lower interest rates, fueling one of the fastest growing asset bubbles of the last decade: the real estate bubble.

Higher interest rates are set by the Federal Reserve when it wishes to slow down growth in the US economy.  Paul Volcker is perhaps the best known Fed chairman because he took rates to their highest level ever in order to cool off stagflation of the 1970s.  By raising the discount rate higher, Volcker reduced demand for loans, and higher interest meant more capital would flow back into the banks and out of the economy, as people made their monthly payments.  This action helped reduce extreme inflation and realign the economy for long term, not short term, growth.

Playing the Fed

Low and high interest rates are usually good for different sectors.  Here are a few ways to play low or high rates.

High Rates

Banking stocks, Treasuries, and other debt are some of the best investments during periods of high interest rates.  In the early 1980s, an astute investor could have invested in corporate debt with returns as high as 22-23%.  That kind of return, extrapolated over many years, is a very good return, especially if one has the foresight to lock it in for the long haul.

Low Rates

Low rates generally prompt lower currency values, which means commodities and foreign currencies usually make excellent investments.  Also, automakers and homebuilders prove to be exceptionally good stock investments, since the two products are usually financed and more people can afford loans at lower rates. 

Predicting the Fed and Interest Rates

If you can reliably predict the actions of the Federal Reserve and the resulting impact on interest rates, you're destined to be a highly profitable trader.  With millions of traders looking up to the Fed Board each month for direction and guidance as to the future direction of the economy, the Fed has more impact than any other institution or organization on stock prices and economic growth.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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