Fed Funds Rate stays at 2%

With the collapse of Lehman Brothers, many were wondering if the Feds will cut their target rates to help keep credit flowing. The FOMC decided to keep rates at 2%. However, the Fed’s statement is interpreted as a “signal it will consider a reduction in the future by acknowledging in its statement that strains in financial markets are increasing.” For a moment predictions showed a marked increase in the probability of the Fed Funds Rate falling to 1.75% but the probability fell immediately after the Feds Funds Rate were held steady.

While the Fed Funds Rate remained at 2%, actual loan rates may be a different story as “the cost of money has risen sharply above the Fed’s 2% target.” Banks have increasingly tightened credit since the sub-prime woes. Local interest rates in Singapore have been more or less stagnant for the past month or so. If it continues to have strong correlation to the Fed Funds Rate then the rates should continue to hover at current levels. However, given the drastic changes in the financial system in the US and its repercussions to the rest of the world, nobody can say for sure what will happen tomorrow. It may well turn out to be a complete meltdown, or hyperinflation or just a recession. Even as i am writing this, gold has just shot up 60 dollars, proving itself indeed to be the ultimate store of value.

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Refinancing 901

I should be expecting a letter from my bank soon, telling me that the interest rate chargeable on my housing loan will be revised to 1.9%, with effect from September 1. This is a second time win for me, having my housing loan interest rate shaved by another 0.1%.

Predictions for the Fed Funds Rate tell us that it looks set to remain at 2% at least until October. Beyond that, “Federal Reserve policy makers agreed this month that their next change in interest rates will be to raise them.”, but we’ll have to wait till the next FOMC meeting announcement to get further clues on when the raise might come. Another factor to consider is the strengthening of the US dollar. The US dollar is still trending up against the Singapore dollar and interest rate parity suggests that interest rates in Singapore will fall as a result, which indeed seems to be the case for now.

Will i still get favourable rates come December when my SOR pegged home loan rates are revised again? I certainly hope so. Short term loan rates such as the 3 months SOR or SIBOR rates should have a good chance of staying lower than the 2 or 3 years fixed rates or floating rates, even after accounting for the1% interest rate banks typically charge on top of SOR or SIBOR. However, if interest rates were to appreciate sharply then i would have lost out on the opportunity to lock-in the current rates. Hopefully i can enjoy reasonable rates for at least the next 2 years with the SOR pegged home loan.

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Inflation and money supply

So far i have become acquainted with the Federal Funds Rate, bonds and foreign exchange. It’s time to look at two very important topics – inflation and money supply. This article looks at some of the implications of events taking place on inflation and money supply. The article presents (presumes) some important concepts and ideas that i thought would be interesting to extract as well as comment on. First, some important definitions from Wikipedia:

  • Inflation means a rise in the general level of prices of goods and services over time. Economists agree that high rates of inflation are caused by high rates of growth of the money supply
  • The money supply refers to the total amount of money held by the nonbank public at a point in time in an economy.
  • The terms fiat currency and fiat money relate to types of currency or money whose usefulness results, not from any intrinsic value or guarantee that it can be converted into gold or another currency, but only from a government’s order (fiat) that it must be accepted as a means of payment.
  • Money creation is the process by which money is produced or issued. There are two different ways to create money:
    • physically manufacturing a new monetary unit, such as paper currency or metal coins
    • loaning out a physical monetary unit multiple times through fractional-reserve lending

Now the article:

  • CPI [Consumer Price Index] is the only inflation measure many people ever focus on even though it is so heavily massaged it borders on fiction (reads: CPI is what they want you to believe inflation is)
  • hard money monetarists view all fiat currency as ultimately doomed stores of value – politicians and bureaucrats will always fall back on the printing press when times get tough and thereby erode the value of that currency. (Governments have the means to print money at will, see point 4 in this wiki entry)
  • In the US, M2 (cash, current account deposits, and short-term savings deposits) have dived, going from a growth of 12% last year to an 8% contraction (so far) this year. This doesn’t bode well for growth figures. (There is a correlation between M2 money supply and nominal GDP)
  • In addition to rocketing CPI, this is also a period of collapsing asset prices in large part generated by the backlash from that housing bubble. The question for markets is which set of price changes should it be responding to? Based on the unprecedented scale of asset price falls we think there is little doubt they will trump headline inflation numbers. (Higher CPI implies interest rates should be raised to curb inflation whereas falling housing or asset prices implies interest rates should be cut to encourage spending and economic growth)
  • With unemployment in the US rising it is difficult imagine wage increases gathering steam. Wage-pushing higher in response [to] price gains has always been the mechanism that imbeds higher inflation and makes it so hard to control. (Price/wage spiral is one of the causes of inflation)
  • Bernanke is a student of the Depression and most agree that credit contraction at the wrong time helped to create and prolong that disaster. Banks are so reluctant to lend right now that we can’t imagine Bernanke adding to the misery. He’s going to keep the lending lines open and there is little chance of a rate gain even in the face of high CPI numbers. (The Federal Reserve’s mission is to keep the economy afloat and avoid recession)
  • We expect continued heavy spending on infrastructure in many regions, and that they could be joined by the US itself post election. The US needs that spending anyway and infrastructure has been proven to be some of the most effective “make work” money. One of the secrets to China’s success has been its willingness, and lack of impediments, to huge funding of money on roads, power, and communications. (Infrastructure spending is an effective way of creating jobs and spurring the economy)
  • Infrastructure spending means “stuff” should to continue to be a winning sector, though maybe not next week or next month in terms of share prices. Commodity prices will continue to be historically strong, but it simply will take a better market environment for anyone to care. (Commodities will still be in high demand, i.e. prices should continue to rise in the long run, despite recent weakness)
  • If shrinking credit markets continue to be the focus, the Fed will continue to be accommodative even while true-market interest rates (the spread) stay relatively high. Back stopping stupid investment banks and trying to rescue homeowners will mean more debt expansion for the US government. That combined with loose monetary policy will keep the US Dollar relatively weak. That will be a boon for gold and silver. (The Fed resorts to injecting liquidity to help rescue banks in trouble and in doing so they devalue the dollar. The recent scramble for dollar may explain why the dollar has gone up at a time when money is being injected)

Here’s a recent update to inflation happening around the world. Further reading up on the monetary system available here.

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Singapore interest rates rise

The 3 month fixing SOR has gone up 0.10% for 2 consecutive days. This is probably attributed to the rising US dollar (falling Singapore dollar). According to interest-rate parity theory, the interest rate has to rise to make up for a fall in the currency so that it maintains parity with another currency.

For home owners on a floating-rate loan package who are keeping track of interest rate movements, perhaps this latest development in foreign exchange points to the need to keep abreast with developments in USD/SGD rates. Among the factors commonly cited for the dollar rise is the softening commodities prices. This report gives some interesting insight as to who was buying the dollar.

How much more will the US dollar rise? Some analysts think “the 5.1 percent growth of dollar against the basket of the 6 most-traded currencies that was seen in the past 3 weeks can’t be sustained by the American economy” (see article). Nevertheless, the US Dollar Index (USDX) is trading above 76 and the futures point to even higher quotes. Only time will tell.

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The bonds connection

It’s hard to write about this subject, but bonds is something that cannot be left out of the equation. i have been pondering for some time what part bonds play in interest rate movements. Does the bond yield lead or trail interest rates? Lets explore that.

For one thing, mortgages in the US are closely linked to bond yield, especially the 10-year Treasury Note. This article explains

Fixed mortgage rates typically track the yield on the 10-year treasury note. “The 30-year mortgage tends to have roughly the same [sensitivity to interest-rate changes] as a 10-year treasury,” says T.J. Marta, a fixed-income strategist at RBC Capital Markets. “On average, people pay off their mortgage roughly every 10 years.” The outlook for inflation plays a key role in determining the yield on the 10-year treasury, Marta says.

In order to compensate lenders and investors for the risk that home loans will not be repaid, mortgage interest rates are set higher than the yields on 10-year treasuries, which are essentially risk free. Historically, the typical difference between mortgage rates and the 10-year treasury yield””known as the spread””has been roughly 1½ percentage points. In the mortgage industry, the difference between these two rates is often referred to as a “risk premium.”

However, that is where the relation ends, as many will tell you (see also this article). Basically long term interest rates are not correlated with short term interest rates, so we can leave the 10 years and above bonds out of the picture. Instead, we want to look at how short term treasuries are related to fed funds rates.

Some googling around leads to this insightful forum thread comment – “The main influence on the T-bill yield is the anticipated FFR. It would be surprising if the T-bill yield did NOT lead FFR.  I would expect the market to have a better idea of what the Fed will do than the Fed itself. That said, the T-bill yield is not the best leading indicator of the FFR. A better leading indicator is the FFR futures rate. That is because there are other influences on the T-bill yield.” So the 3 months treasury bill yield and the Fed Funds Rate Futures are useful lead indicators of the Fed Funds Rate.

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Fed funds rate unchanged at 2%

The Federal Open Market Committee (FOMC) has kept the federal funds rate at 2.0% – news that is not news since it was widely anticipated. What is more important to note perhaps, is that “in its statement, the Fed gave no sign that it plans to change policy in the foreseeable future.”

Excerpts from news sources

  • many economists believe the Fed won’t move rates in either direction until after the presidential election
  • the Fed will keep rates at 2% until at least December, if not early next year
  • unless a major bank goes under, the Fed’s next move will be to eventually raise rates

SIBOR and SOR have been trending lower recently. Lets hope it will stay that way at least until early next year so i can capitalize on it, heh.

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Studies have shown..

Found another article explaining Interbank Interest Rate Determination in Singapore. Published in 1999 by the Monetary Authority of Singapore (MAS), it stipulates that

Only changes in US interest rates or market expectations of future movements in the exchange rate have a significant impact on the domestic interbank rate.

That should be enough proof that SIBOR and SOR tracks interest rates in the US. This chart of the US 3 months interbank rate may be a useful resource.

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Interest rate parity

One step forward in my quest on what moves interest ratesinterest rate parity. Simply put, this theory states that

the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

In other words, the total sum (principal + interest) in currency A at the end of a given time period should equal the total sum if currency A is first converted into currency B, invested for interest, and converted back to currency A at the end of the same period.

This is one reason behind lower interest rates in Singapore, as the Singapore dollar has appreciated against the US dollar over the last one year. The interest rate parity theory can only be used as a guide though. As explained in this article, Singapore interest rates have been lower than the implied rates from the interest-parity modelling:

Singapore’s domestic short-term interest rates have since April [2007]stayed below the implied short-term rates suggested by our equilibrium interest-parity modelling. We suspect that this reflects a deliberate strategy by the MAS to maintain enough liquidity in the local system to keep domestic interest rates low and shield the Singapore dollar from becoming a target currency for the yen carry trade.

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Fixed rate package interest rates trending up

Since fixed rate home loan rates are rarely published online, i decided to do a survey in person. I went to a bank i have been to five months back and found out that indeed the 1 year fixed rate package is now at 3.68% as reported. The last time i was there it was 2.68%, a whopping 1% increase!

The fixed rate package scheme is a tricky business for banks. Banks will have to make a good guess as to what interest rates will be like in 2 or 3 years’ time. If the rates turn out to be higher than expected, they will be paying higher interests on the cash that they in turn are loaning out and their margins will be squeezed. Hence banks have to be very conservative and quote a safe (as in high) rate.

Looking at the way interest rates are moving, i must say that people who have chosen a 2 or 3 years lock-in five months ago have chosen wisely. They can have peace of mind for the next 2 or 3 years. For the rest of us who can stomach more risk in opting for variable rate packages, lets hope the current savings in interests will still be able to offset the increase in future interest payments, and lets hope your investments will do better than 4%. All the best!

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