Effects of Federal interest rate .?
1. Dow jones would go up or down.why?
2.. gold price would go up and down...? why?
3. U.S $ would become stronger or weaker? why
Answers:
1) Dow jones would go up as the portfolio theory suggests that given a lower interest rate or price of investment leads to a increase in demand for assets. The stock is valued in theory based on the stream of infinite dividends it pays. it can represented by:
PV=[D/(1+r)^(n)] in its simple form.
where "PV" is the price of the stock, "D" is the divend, "r" is the interest rate and "n" is the number of the payment.
if interest rates go down then the (1+r)^n factor will decrease, which results in the value of the stock increasing.
2) NOT SURE ABOUT THIS ONE: Interest rates when cut result in a portfolio adjustment where the demand for assets increase. So people invest their money in any assets including gold.
However, from a business point of view i can see the decrease in interst rates resulting in an increase in captial expediture by mining and other extractive firms leading to a lower price of gold if in fact the supply of gold is increased. However, i think the frist option is perhaps a better explanation.
3) If interest rates go down then the immeadiate effect on exchange is a lower level of Net Capital Inflow (NCI), that is foreign investments will decrease. So supply of FX will decrease. as a result the US dollar will go up. This compouded by the demand side effect that boosts conumers marginal propensity to consumer on imports will result in an increase in the demand for FX and again result in a increase in the US dollar.
FX = foreign exchange.
1. Dow would go up because it relieves borrowing pressure, making borrowing easier for the economy and therefore stimulate growth.
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If the fed cut interest rates then the rates of many other types of interest bearing products will also be cut as they depend on that rate, sorta follow the rate, or compete with products that sorta follow the rate. Since interest rates are being cut in many areas, people are less interested in putting their money in interest bearing products so they may move some money to stocks, so the stock market goes up - at least a little. Thus, #1 goes up. Also see the answer to #2 for another reason stocks may go up with an interest rate cut (as inflation also causes stocks to go up).
For #2, I don't think its completely clear, but lower interest rates do mean higher inflation (thats why interest rates are usually raised, to slow things down if inflation threatens) and higher inflation means higher prices for gold (since its a hedge againist inflation) as well as all other commodities. So interest rate cut means gold goes up.
For #3, interest rates are typically cut during a weak economy to increase investment (if interest rates are low you can borrow more and thus grow your business faster), so interest rate cuts strengthen the economy.
Interesting question - requires a long answer to do it justice, unfortunately.
It is a bit of a trick question. The reaction depends to what extent it had been expected. In general, the impact of a piece of data is mostly driven by the component that is *unexpected*. (Just like when a stock reports earnings, it trades on whether it beat numbers (expectations), not so much the reported numbers themselves. On the day of the announcement, if the cut was expected, there would probably be very little reaction to news of the cut, apart from trading based on analysis of the fed's statement.
So I would say, to the extent a fed rate cut was unexpected, or to the extent expectations were moving towards a fed rate cut:
1. Dow Jones would appreciate:
Lower rates would be expected to stimulate the economy, and would help equities from a valuation perspective (lower discount rate to be applied). I think this is fairly intuitive and is well-supported by the data.
2. Gold would typically go down (maybe)
This is a much weaker association than the other two, and is only pronounced over the longer term. You might think the lower rates means inflation fears, which means people want to hold real assets like gold, but it is a little more subtle than that. People realize that if the fed is *willing* to lower rates at a particular point in time, then inflation pressures must be subsiding, so gold is more likely to fall. On the other hand, if the fed is scared of inflation and raising rates, then investors fear inflation as well and bid up the price of gold. The counter-argument is more plausible if you think the fed is not credible. (i.e. willing to lower rates when it should not because of inflationary pressure).
If you look historically at a plot of the two, the two eras that stick out are the early 80's (fed raising rates and gold rising), and 04-07 (same). There are counterexamples as well.
3. USD would typically become weaker.
This one is pretty straightforward. Higher rates tend to attract investment flows, which tend to push up currencies, and lower rates tend to lead to investment elsewhere, which pushes currencies down. Just look at a few currency stories on Bloomberg to see this one in effect. (Try http://www.google.com/search?hl=en&clien... ) A contemporary example you'll hear people talking about often is the "carry trade" of selling Yen (as Japan has a short rate of about .50%) and investing in markets with higher yielding rates.
So there you go. The one caveat is - if investors think the fed is lowering rates because things are getting really really bad, and are caught off guard, the first answer may be reversed. For example, if the Fed lowers rates tomorrow (inter-meeting, like 1/3/01), and says it is because the housing/subprime mess is really blowing up more than anyone is realizing, you can imagine that hits the stock market.
1. Dow jones would go up coz of the optimism that this would help accelerate the economy and it makes people want to take more risks.
2. Gold price would go up as a result of weaker US dollar and investors looking for higher yields.
3. US dollar would weaken coz it has lost its yield advantage over other majors.
The effect will not last forever though, once this has been priced into the markets, people will start looking for fresh news for directions.
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