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Since traders are constantly trying to predict the next direction of interest rates, the economic news can have a significant effect on the financial marketsKEY INTEREST RATE INDICATORS Putting together a broad market analysis requires a feeling for where interest rates might be headed. In order to do this, the analyst needs a clear understanding of three key indicators: the prime rate indicator, the Federal Reserve indicator, and the installment debt indicator. Each indicator provides important clues pertaining to future interest rate trends. The prime rate indicator represents the interest rate that banking institutions require their very best customers to pay which more often than not are the top corporations in the country. The majority of bank loans actually made are pegged to the prime rate with a premium being charged relative to the degree of risk of the loan. So, the worse off the borrowers credit rating, the more the borrower will pay above the prime rate. Following prime rate changes is relatively easy since it does not change every day, as do other interest rates. In addition, when the prime rate indeed does change it is hard to miss it since it is plastered all over the news. Also, this indicator lags behind other interest rates. For example, the prime rate typically declines only well after a decrease in the federal funds rate or certificates of deposit yields. But these prime rate changes should be monitored closely because many times when a distinct trend can be identified then this can translate into corresponding movement in the equity markets. The Federal Reserve indicator consists of two of its primary monetary policy tools: the discount rate and reserve requirements. The discount rate is how much the Federal Reserve charges banking institutions that wish to borrow from it. And why would banks ever want to borrow from the Federal Reserve? The answer is to satisfy their reserve requirements, which are also controlled by the Fed. These requirement levels basically determine the banks loan making ability. Just like the prime rate, the Feds adjustments to the discount rate and/or reserve requirements garner a lot of media attention, which makes changes quite easy to track. These two data points are rarely changed within the course of a year. The key information that is critical for the analyst to capture is the directional change in either of these two key monetary tools. Finally, the other key piece of information in determining interest rate trends is the installment debt indicator. This indicator gauges the level of loan demand in the country. This demand has a large impact on the direction of interest rates. If loan demand increases significantly interest rates tend to increase. When loan demand decreases at a sharp level the interest rates are likely to decline. Loan demand is measured from a variety of sources, which include state, federal, and local governments; corporations using short-term commercial loans and longer-term bond market monies; mortgage debt; and consumer installment debt. Again, just like the other indicators, this data is simple to track. Keep in mind that when the monthly total of this debt is released by the Federal Reserve it is about six weeks late; however, the important thing to note is how this figure is trending. This can gives us a keen insight into the future direction of interest rates. All three of these interest rate forecasting tools are not only extremely easy to track but easy to interpret as well. And as indicators go, that is exactly how they should be if they are going to be effective. If you are a fundamental analyst who likes to adopt a broad market view before investing, then I suggest adopting these tools as part of your overall approach. THE ECONOMIC DATA Since traders are constantly trying to predict the next direction of interest rates, the economic news can have a significant effect on the financial markets. Often, signs of a strong economy can trigger concerns about the prospect of inflation, which has historically led to higher interest rates. In addition, inflation is also a concern due to its adverse impact on corporate profits. There are several pieces of economic data that can give clues regarding the trends in inflation. For instance, the prices-paid element of the Institute of Supply Management (ISM) manufacturing report, which is released monthly, can serve as a guide report that gauges inflation. If prices paid are too strong, stocks and bonds might react negatively to the news. The Consumer Price Index (CPI) measures prices on consumer goods and services, and the Producer Price Index (PPI) gauges prices on various goods such as commodities, capital items, automobiles, and textiles. Both should be watched for inflationary pressures. Some traders also watch trends in the commodities market for signs of inflation. The Commodity Research Bureau provides an index of commodity prices known as the CRB. When it is rising, it is a sign of rising commodity prices and, sometimes, mounting inflationary pressures. A host of other economic reports receive the markets attention on a regular basis. Bond traders sometimes call the monthly unemployment report from the Labor Department the unenjoyment report because stocks and bonds sometimes slide following the release of the monthly numbers. It is released on the first Friday of every month. Figures on retail sales, housing, motor vehicle sales, and consumer sentiment numbers can also cause a reaction on the financial markets. Table 15.1 shows a list of important economic indicators. THE IMPORTANT ROLE OF THE FEDERAL RESERVE Another major reason you should keep track of economic reports is because they can influence the decisions at the Federal Reserve. Just what is the Federal Reserve? Most people believe that it is the branch of the U.S. government charged with making monetary policy decisions. Most people are wrong. While its true that the Federal Reserve makes U.S. monetary policy, it is an independent group. The U.S. government was on the verge of bankruptcy back in the early 19-teens. Twelve very wealthy families actually stepped forward to bail out the government, and Congress officially created the Federal Reserve in 1913. Today, the Federal Reserve consists of 12 district banks as well as a board of governors. Alan Greenspan is currently the Fed chairman. Today, the Federal Reserve works more like a government agency than a corporation. The chairman of the Federal Reserve and his fellow central bankers play a key role in influencing the money supply. As a trader, it is vital to examine how open market operations are one of the primary tools used by the Federal Reserve to implement U.S. monetary policy. You can also track the profound impacts these decisions have on the U.S. economy, as well as the key reports that are monitored to determine if the Fed is indeed meeting its intended goals. Advancing Numbers A rise in unemployment rate is often seen as a negative for stocks but a positive for bonds. If the wholesale trade inventories number rises, consumption is slowing. Rising inventory-to-sales ratio reflects a slowdown in the economy. Imports constitute 15 percent of U.S. consumption, and also directly affect the profitability of U.S. 389 Declining Numbers A decrease in unemployment numbers is a positive sign for the economy. If wholesale trade inventories are falling, consumption is on the rise. If this inventory to sales ratio begins to fall, consumer spending increases (more confidence). If import prices fall, U.S. companies must lower prices to compete. This is bad for businesses, good for the consumer. companies. Higher prices for imports translate to higher prices for domestic goods. This is good news for businesses; bad for the consumer. a quarter, toward end of month, for preceding quarter Around the 15th of each month, 8:30 A.M., EST Analyzes wages and fringe benefits. Rising wages alone have less meaning, but are used in conjunction with other reports, like housing starts. Since the CPI describes price changes of a basket of consumer goods. A rising number means inflationary pressures at work. This is bad for the market Lower wages mean a slowing economy, and will be used in conjunction with other economic measurements to gauge the economys strength. A drop in prices is generally considered a good sign for consumers and good for the market. Too much of a drop is a negative, or a sign of possible deflation. because inflation is held in check with rising interest rates. rate cuts. If rates are increasing, this is bad because further rate hikes may be required. First of month of Supply Management Index (ISM) Retail sales Midmonth Gross One month Domestic after end of Product quarter (GDP) Housing Third week of starts month and sales of new and existing homes Construction First of month spending Above 50 percent indicates economic expansion. If people are spending more and confidence is high, its a good sign for the market. GDP takes into account consumer demand, trade balance, and so on. Economy expanding is good news, but not too fast the Fed raises rates when that happens. Increasing starts indicate confidence a good sign for the market. Lagging indicator. Reports come in only after building is finished. An increase in numbers is a good sign. Below 50 percent suggests economic contraction. If people spend less and confidence shrinks, its a bad sign for the market, especially retail stocks. Economy slowing. If it continues Fed will (possibly) lower rates, which is good for the market. Decreasing starts indicate economy slowing. Red flag for Fed to be on lookout for downturn in economy. Market reaction is anybodys guess. Since its a lagging indicator, it may serve to confirm the economy is slowing and rates need to be lowered. Good for the market. Declining Numbers Decreasing numbers indicate factories are slowing down. Might be considered bad for the market, is considered bad for the economy. Prolonged decrease in consumer demand is definitely bad for consumer stocks. Slowing demand means a slowing economy, if it stays in a declining mode for several months. Might adversely affect markets, but if it prompts interest rate reductions it could be good. The Federal Reserve actually has three tools at its disposal to carry out monetary policy: open market operations, discount rate, and reserve requirements. Open market operations are by far the most widely used mechanism. When the economy is growing too fast and the inflation rate is high, the Federal Reserve will sell government securities from its portfolio to the open market. This decreases bank reserves, which means the money supply decreases. When there are less bank reserves, short-term interest rates increase. This means consumers and businesses have to pay the bank more in order to borrow money. Less borrowing means less spending, which slows the economy and eventually can reduce price pressures. However, if the economy is growing too slowly and the inflation rate is low, the Federal Reserve will buy government securities, such as Treasury bills and notes. This increases bank reserves, which increases the money supply and causes short-term interest rates to decrease. Reduced rates induce consumers and businesses to borrow. Consumers will borrow money for items such as automobiles or homes. Businesses borrow to build their inventories or finance new factories. As a result, economic growth will accelerate. The Federal Reserve will also leave rates unchanged if the economy is growing at a moderate pace with low inflation or if they feel the economy will slow down by itself. They will even take a wait-and-see approach with regard to how fast or how slowly the economy is growing and the rate of inflation, before determining monetary policy. The major goals of the Federal Reserve include moderate growth, low unemployment, and low inflation. To determine how these open market operations have been impacting these areas, the Fed monitors the key related reports for feedback. Economic growth is measured by the gross domestic product, which consists of consumption, investment, government, and exports. The retail sales report would fall under consumption. Business inventories and housing starts would fall under investment. Construction spending would fall under government, and international trade would fall under exports. Other reports include the employment report, which includes the unemployment rate and is also closely monitored by the Federal Reserve. Finally, the Producer Price Index, Consumer Price Index, capacity utilization rates, and Employment Cost Index are all monitored to determine the current inflation outlook. As these reports are released week-by-week, a consensus is developed among policy makers as to whether the economy and the inflation rate are growing too fast, too slow, or just right. They look for the evidence and then they take a vote on whether to raise or lower rates or leave them unchanged. The bottom line is that the Federal Reserve chairman and fellow central bankers have a great influence on our economy and should be watched closely. The primary goals of the Federal Reserve are to stabilize prices, promote economic growth, and strive for full employment. These goals are pursued through managing monetary policy, which is implemented by the Federal Open Market Committee (FOMC). The FOMC includes seven Fed governors as well five presidents of the district banks. Four of the presidents serve on a rotating basis. The FOMCs most frequently used tool to control monetary policy is open market operations. Open market operations means the buying or selling of government securities to control liquidity in the economy. Thats what is happening when you hear that liquidity is going up or down in the economy. When liquidity is high, it makes it easier for businesses to borrow money, which in turn leads to more research and development (R&D) spending, which leads to growth. Have you ever really looked at a dollar bill? Across the top it says Federal Reserve Note. It didnt always. I actually have a 1917 United States dollar framed on the wall in my office; it was the last year they were printed. How about the back of the current dollar bill? There is a pyramid with an eye on the top and a banner along the bottom with a slogan that stands for New World Order. (Thats the original name the 12 families who bailed out the government in 1913 coined for themselves.) Our old money had an X across the back with the words United States of America embodied in the X. Thats enough history and economics; now lets examine more recent Fed moves. As the market was racing forward at the end of the 1990s, many may remember the famous irrational exuberance speech from Fed Chairman Alan Greenspan. The sad thing is that the Fed helped create that exuberance. In 1999, the Fed began injecting massive doses of liquidity into the economy in anticipation of Y2K. It wanted to make sure businesses had plenty of easily available money. Banks actually had more money than they could lend. So where did all this money end up? Thats right, the stock market. And what was in vogue at the time? The unknown Internet sector. This just further fueled the raging bull market that already existed. After Y2K arrived with few problems, the Fed began rapidly draining that liquidity back out of the market. At the same time, the Fed was concerned about the rapid growth of our economy. Surely, an economy growing at 6 to 7 percent would spur wild inflation, even though there were no signs of it anywhere. So at the same time the Fed was withdrawing liquidity, it was raising interest rates to tap the brakes on the economy. What is so frustrating is that everyone knows that interest rate cuts or hikes take time to affect the economy. The Fed kept pressing that brake with more rate hikes because the economy still looked so healthy. We now see the results of what withdrawing liquidity combined with rate hikes can do to businesses and a healthy economy. The effect has been more of slamming on the brakes and jamming the gears into reverse. Was there an Internet bubble? Sure there was: It would have eventually become apparent anyway that all those dot-coms were never going to make a profit. The bubble would have suffered a slow leak until it disappeared altogether. Instead, we got a painful pop. Could our economy have continued to grow at such a rapid pace without rampant inflation? If you believe in the free enterprise system, supply will always meet demand. Take away the demand and look what happens. |
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