Will the Fed Continue to Cut Rates?
By Tim W Wood CPA, September 7, 2007
It seems like the hot debate on the upcoming Fed meeting is whether or not they will cut the discount rate. Given that we had a cut in August, I'm not sure if we will see another cut in September. But, I can tell you that at present, the charts do in fact say that we have entered into an environment in which rates will continue to be cut over the longer-term. Here's why.
Below is a chart of the 3-month T-Bill going back into the 1940's. I have also plotted my Trend Indicator along with price. Note that when the Trend Indicator turns, it signals or confirms major trend changes for interest rates. Given that this indicator has recently turned down, all indications are that interest rates are now headed lower, and this outlook will not change until the Trend Indicator turns back up.
Now I want to show you another chart and discuss a widespread market myth. It seems that many people are of the opinion that the Fed dictates or sets interest rates. I realize that you can’tsee enough detail in the chart below to see this for yourself, but when looking at this chart up close, I can tell you without a doubt the market in fact determines the interest rates and the Fed actually follows the market.
In going back to 1946 the market has lead the Fed at every major turn in interest rates. Yes, the market leads and the Fed follows. The latest example of this occurred during the 2000 to 2004 timeframe. In November 2000 the 3-month T-Bill was at 6.22% and the Discount Rate was sitting at 7.50%. By January 2001 the T-Bill rate had fallen to 5.70%, which widened the spread between the Discount Rate and the T-Bill rate from 1.28% to 1.80%. It was at that time that the Fed began cutting the Discount Rate and they continued cutting the Discount Rate as they followed the rates lower as was being set by the market. The 3-month T-Bill rate finally hit bottom in June 2003 at .82%. From there, rates stabilized and rose to 1.39% in June 2004. It was then in July 2004 that the Fed began raising the Discount Rate once again as they followed the natural tendency of the market. As T-Bill rates and interest rates in general steadily rose from mid-2004 into early 2006, the Fed continued following suit with higher rates. As the 3-month T-Bill stabilized at around 5% from mid-2006 into mid-2007, the Discount Rate was left unchanged at 6.25%. It was not until the drastic drop in rates seen in August that the Fed stepped forward for another rate cut.
Since August the short-term rates have recovered and perhaps the sharp drop was just an anomaly, and perhaps interest rates will stabilize. But in the meantime, my Trend Indicator remains negative, indicating that a major trend change has occurred. If this was just an anomaly, then the Trend Indicator will ultimately turn back up. Until such time we have to play the cards based on the last hand we were dealt, and that hand turned the Trend Indicator down. So until this changes, we can now only assume that we have in fact seen another major trend change in interest rates and that the bias now is toward lower rates. Does this mean that the Fed will cut in September? Given that the 3-month T-Bill has recently rebounded from 2.85% back up to around 4.6%, it is possible that the Fed may choose to sit tight in the September meeting. But, as long as the Trend Indicator remains negative any bounce in interest rates has to be viewed as a counter-trend move. In which case the current rebound is not expected to continue, and once rates begin to decline again, we should then see the Fed following the lead of the market. The bottom line is that we have now entered into an environment in which we can expect future cuts in the Discount Rate. It is extremely important to watch the Trend Indicator as well as the Cycle Turn Indicator in regard to the future trend of interest rates as this will let us know if/when this environment has changed.
Now let's assume for the moment that this was not an anomaly and that interest rates do continue lower. The market place will look at this as if the Fed is saving the day, when in fact they are just following the market. Somehow the world has become fixed on the perception of the Fed's actions toward cutting the Discount Rate rather than the reality. Nonetheless, this will not fix the sub-prime and other outstanding mortgage issues. These problems are not going to simply go away as a result of lower interest rates. Also, lower rates are not likely to fix the woes of the stock market this time around either. I warned of the housing top in late 2005. I have been warning that the stock market has been in one of the longest 4-year cycles in stock market history without the required and natural correction. We are only just beginning to see the unwinding. You have been warned.
Tim W. Wood
© 2007 Tim Wood