Reacting to a Federal Reserve Policy Change
On Feb. 18, after the market closed, the Federal Reserve announced a change in monetary policy. According to the press relase, press release that "in light of continued improvement in financial market conditions the Federal Reserve Board had unanimously approved several modifications to the terms of its discount window lending programs." Changes included approval from the board of a 0.25-point increase to the primary credit rate, or discount rate, from 0.5% to 0.75%.
The markets reacted immediately. U.S. equity
traded lower, the dollar rose, and the price of gold declined.
With a decision slated to come tomorrow from the Fed regarding interest rates, our task now is to take apart this previous action and the subsequent market reactions in order to understand them and their implications in greater detail. We need to ask ourselves: How can we take advantage of the implications of a change (actual or perceived) in monetary policy? We also need to ask: What does this mean for my investments?
Let's take this one at a time.
1. Why did the dollar appreciate?
When interest rates rise in a home country without corresponding changes in a foreign country, demand will increase for the home country currency. The reason for this is described in a theory referred to as interest rate parity, which deals with interest rate dynamics as they relate to currency exchange rates. Prior to the interest rate change, the currency exchange rates were in a state of equilibrium. Once a home country's rates increase, interest earnings for the home country currency will increase relative to the foreign country currency. The spot rate of the home country will then appreciate to reflect a no-arbitrage condition, and the currencies will return to equilibrium. Since U.S. interest rates are perceived to be rising, so will the dollar.
The foreign exchange market is the most active market in the world. The number of transactions and monetary value of foreign exchange trades dwarf the market of any other security type (such as stocks or bonds). Individual investors can transact in the foreign exchange market in one of two readily available markets:
Using exchange-traded funds such as the PowerShares DB U.S. Dollar Index Bullish ETF or the PowerShares DB U.S. Dollar Index Bearish ETF
Opening up a self-directed currency trading account. You can do so at Gain Capital or Forex.com
2. Why is gold falling?
In 1944, the Bretton Woods Agreement established the International Monetary Fund and the gold standard. Under the gold standard, an international monetary system was established that converted currencies into the U.S. dollar, which was in turn convertible into gold at a fixed price.
That system existed until 1971, when President Richard Nixon took the dollar off of the gold standard, thus allowing all currencies to float. What now occurs is that gold traders and speculators will use gold as a hedge against inflation and the dollar. Should the dollar depreciate, then it will take more dollars to buy gold. Hence, the price of gold will increase. Should the dollar appreciate, as it appears to have done after the Feb. 18 Federal Reserve announcement, then it will take fewer dollars to buy gold. Hence, the price of gold will decrease.
The most readily available way to access the precious metals markets is again through the use of ETFs, such as
SPDR Gold Trust
(GLD) - Get Report
,
iShares Silver Trust
(SLV) - Get Report
and
EFTS Physical Platinum Shares
(PPLT) - Get Report
.
3. Why are stock index futures falling?
When interest rates increase, investors begin to fear that one or more of the following conditions will result:
Fixed income investments, those that pay interest to investors, will be preferred to stock investments, and portfolio asset reallocations will take place from stocks to bonds.
The cost of financing debt for public companies will rise. In financial theory, we look at the weighted average cost of capital, which includes the cost of financing capital through debt issuance. As WACC rises, hurdle rates (returns) for new projects must also rise in order for the company to undertake the project. Thus, capital expenditures (capex) might decrease, slowing economic activity along the way.
The consumer credit cost of borrowing will increase as banks require higher interest rates on loans to offset their higher borrowing costs. Consumers will borrow less and thus purchase less. Retail-related activity such as consumer durables (automobiles, washing machines) as well as consumer discretionary items or soft goods (clothing, personal products) may decline.
When you put that all together, there are fears that gross domestic product and hence economic growth will decline, corporate profits will contract and the stock market will decline.
There are several ways that investors can play these perceived phenomena:
Hedge your portfolio by shorting ETFs such as Retail HOLDRs , S&P 500 SPDR or Consumer Discretionary Select . You can also buy inverse ETFs such as Short S&P 500 or UltraShort S&P 500 . As always, be careful as to the nonlinear and leveraged nature of the leverage ETF products
Move your portfolio into a more defensive posture by buying staples product companies. Often we look for such products in the kitchen cupboard or medicine cabinet, from household names such as Gillette , Proctor & Gamble , General Mills , Kraft ( KFT) and Kellogg . You can get broader coverage in this sector with the Consumer Staples SPDR .
Allocate more assets from stocks into fixed income. However, I would suggest staying on the short end of the curve (lesser maturities) than the long end (longer maturities) to minimize risk against further interest rate increases.
As it turned out, negative reaction by traders, born out of fear to perceptions of the implications in the Federal Reserve's February action, was short-lived. In fact, the markets have been in rally mode ever since the initial selloff on the news.
The question now is: Are these perceptions true in reality? In my next article, I'll discuss how the S&P 500 has actually performed after the beginning of a new tightening cycle.
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At the time of publication, Rothbort had no positions in stocks mentioned, although positions can change at any time.
Scott Rothbort has over 25 years of experience in the financial services industry. He is the Founder and President of
, a registered investment advisor specializing in customized separate account management for high net worth individuals. In addition, he is the founder of
, an educational social networking site; and, publisher of
The LakeView Restaurant & Food Chain Report
. Rothbort is also a Term Professor of Finance at Seton Hall University's Stillman School of Business, where he teaches courses in finance and economics. He is the Chief Market Strategist for The Stillman School of Business and the co-supervisor of the Center for Securities Trading and Analysis.
Mr. Rothbort is a regular contributor to
TheStreet.com's RealMoney Silver
website and has frequently appeared as a professional guest on
Bloomberg Radio
,
Bloomberg Television
,
Fox Business Network
,
CNBC Television
,
TheStreet.com TV
and local television. As an expert in the field of derivatives and exchange-traded funds (ETFs), he frequently speaks at industry conferences. He is an ETF advisory board member for the Information Management Network, a global organizer of institutional finance and investment conferences. In addition, he is widely quoted in interviews in the printed press and on the internet.
Mr. Rothbort founded LakeView Asset Management in 2002. Prior to that, since 1991, he worked at Merrill Lynch, where he held a wide variety of senior-level management positions, including Business Director for the Global Equity Derivative Department, Global Director for Equity Swaps Trading and Risk Management, and Director for secured funding and collateral management for the Global Capital Markets Group and Corporate Treasury. Prior to working at Merrill Lynch, within the financial services industry, he worked for County Nat West Securities and Morgan Stanley, where he had international assignments in Tokyo, Hong Kong and London. He began his career working at Price Waterhouse from 1982 to 1984.
Mr. Rothbort received an M.B.A., majoring in Finance and International Business from the Stern School of Business, New York University, in 1992, and a B.Sc. in Economics, majoring in Accounting, from the Wharton School of Business, University of Pennsylvania, in 1982. He is also a graduate of the prestigious Stuyvesant High School in New York City. Mr. Rothbort is married to Layni Horowitz Rothbort, a real estate attorney, and together they have five children.