HISTORY OF FED RATE CUTS AND ITS EFFECTS
Manager Research, PAGE
Jan 28 - Feb 03, 2008
Since January 1990 Fed has changed its rate for 72 times and it involved 41 raises and 31 cuts in the fund rate. On the other hand discount rate was slashed on 28 occasions and raised on 26. There have been 13 periods since 1921 in which the Fed has delivered three rate cuts in relatively quick succession and the most recent dose of this sort of monetary medicine came in the fall of 1998. The emergent Fed interest rate cut to 3.5% recently had a comforting effect on the international markets. However it will take a longer time to come out of that scenario as billion of dollars have been written by big banks and trillion of dollars are stuck up in sub-prime mortgage.
ORIGINS OF THE SUB-PRIME CRISIS
* Usage of brokerage channel to originate loans - underwriters have no direct contact with the borrowers.
* Securitization - while this in itself is not an underwriting weakness, multiple layers of securitization through creation of CDO structures "enhanced" credit ratings which clearly were not viable.
* Teaser interest rates and flexibility to even service only minimum payments drove negative amortization (similar to a credit card) - as rates rose, borrowers found cash flow difficulties.
* Rising interest rates - the FED reversed its interest rate policy starting May 2004 and a persistent rise in interest rates created cash flow difficulties for borrowers as RM mortgages reset.
* Increase in Oil Prices - The sub-prime segment is often associated with usage of cars to commute and higher oil prices resulted in cash flow problems.
* Inflation/ food price inflation - This caused additional cash flow problems Despite what appeared to be a healthy jobs market, consumer credit has come under pressure from the above liquidity triggers.
EFFECT OF RATE CUT
The impact of the rate cut on the international stock markets would be felt worldwide, but the magnitude would differ from country to country.
EFFECT ON WORLD MARKETS
Interest rate cuts are always welcome events for equities. In the past cases, the stock market was almost always higher a year after the third rate cut. The one exception was 1930, the beginning of the Depression. Twelve months after Feb. 7, 1930, the date of the Fed's third rate cut, the Dow Jones industrial average had fallen by more than 35 percent. The rest of the record is more impressive: for the other periods, the Dow was up an average of 21 percent 12 months after the last of the Fed's three rate cuts. But lately they become particularly potent when the central bank doles out three or more in relatively rapid succession. If the past is an accurate indicator of future performance, the Fed will lower borrowing costs again and the market will rise over the next 12 months.
EFFECT ON MIDDLE EASTERN MARKETS
Interest rate cuts would have a positive impact on the markets of the Middle East as they follow the policy of the America. The countries in the Middle-East has more of the earnings coming from different sources of the oil so for them excess liquidity and Petro-dollar money would be quite beneficial at such point in time.
EFFECT ON ASIAN MARKETS
Impact of the rate cut would be wide ranging on the Asian markets which are dependant upon their trade with US. Countries like China and India would have a far reaching impact as they export heavily to US. Apart from that most of Asian banks, direct exposures to US subprime remain limited. Most Asian banks/ FIs have operated largely on a domestic basis and hence have no meaningful loans to the subprime segment. Direct exposures exist mainly as investments in subprime related securities (ABS and CDOs) which have witnessed significant deterioration in market values.
EFFECT ON PAKISTANI MARKETS
Although Pakistan market doesn't correlate much with the World markets but the impact can be there as the foreign investors gauge all their own country parameters and their strength before investing in other country. Pakistani market as per recent data has been taken over greatly by foreign institution which has taken good control of the free-float. Apart from that the inflow of remittance and investment apart from the stock market can also impact the country as well. On the export front, Pakistan exports to US are not that high compared to other bigger Asian economies such as India and China hence the blow might be bearable until the world economic managers find something more than the interest rate cut, to put a floor under the fall towards recession.
A full-blown, prolonged recession in America is now inescapable, with the rest of the world set to be dragged into a severe global slowdown despite recent emergency US interest rate cut by the Federal Reserve. A darkening outlook for the global economy looked set to dominate, as plunging stock markets and the Fed's drastic and dramatic reaction have overshadowed many positives. Going forward it is believed that Fed would be undergoing more cuts, would reduce its expenditure on wars and would give much needed tax benefits to the business community so as to come out from this tethering situation.