We can see the linkage between the price of crude oil and the high yield debt prices as represented by the price of Barclays High Yield Bond ETF (JNK-blue line) and the price of the West Texas Intermediate crude ($WTIC-red line). The price of oil is shown on the left axis and the price of JNK is shown on the right axis.

 

Energy companies now constitute approximately 15% of the high yield bond market, up from 8% in 2008.

Everything was fine when oil was north of $100 a barrel. But many of these independent drillers that can profitably extract oil when it is trading at $100 a barrel are now potentially less or not profitable as oil has fallen to its current levels and positive cash flow lessens or evaporates. The costs for the various shale oil drillers are all over the map but most independent drillers hit a break-even around $80-$85 per barrel.

12-11-MC-2

 

It is amazing how much of an impact a small increase in interest rates can have on your hard earned principal. These interest rate increases, as we saw from our first example, aren’t always over a long period of time. In our example, the interest rate on the 10-year U.S. Treasury note fell and then moved up 0.35% in just one morning. While this was an outlier event, it does show that rates can move rapidly if market views on interest rates change suddenly.

In order to illustrate this relationship between interest rate increases and the impact on the principal value of your investment, we present five interest rate increase scenarios below. The “initial” point is where your investment is made into the iShare Barclays 20+ Year Treasury Bond ETF, in this case the current interest rate on the 20-year U.S. Treasury is 2.70%. We then show how over a three month time frame the prevailing interest rate rises in 30 basis point increments, ranging from a 0.30% to a 1.50% interest rate increase.

122MC2

 

OTHER TYPES OF BONDS

A zero-coupon bond (also discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity.[1] Note that this definition assumes a positive time value of money. It does not make periodic interest payments, or have so-called “coupons”, hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zero-coupon bonds,[1] and any type of coupon bond that has been stripped of its coupons.

In contrast, an investor who has a regular bond receives income from coupon payments, which are usually made semi-annually. The investor also receives the principal or face value of the investment when the bond matures.

Some zero coupon bonds are inflation indexed, so the amount of money that will be paid to the bond holder is calculated to have a set amount of purchasing power rather than a set amount of money, but the majority of zero coupon bonds pay a set amount of money known as the face value of the bond.

Zero coupon bonds may be long or short term investments. Long-term zero coupon maturity dates typically start at ten to fifteen years. The bonds can be held until maturity or sold on secondary bond markets. Short-term zero coupon bonds generally have maturities of less than one year and are called bills. The U.S. Treasury bill market is the most active and liquid debt market in the world.

 

OTHER INFO

2) Treasury Bond Rates: As shared above, there is an important historical relationship between Treasury bonds and the valuation of the stock market. Right now that is very favorable for stocks as bond rates have come down significantly over the past year. And signs point to rates staying low for quite some time.

However, you can easily appreciate that if rates started to rise significantly, then it would have a negative effect on stock prices. I believe stocks will do fine if rates just float up to around 3%. Above that and it will start to call into question their relative value versus bonds, which would spark a correction even if other economic indicators are positive.

Cross listing of one company on multiple exchanges should not be confused with dual listed companies, where two distinct companies – with separate stocks listed on different exchanges – function as one company.

Cross listing of shares is when a firm lists its equity shares on one or more foreign stock exchange in addition to its domestic exchange. Examples include: American Depositary Receipt (ADR), European Depositary Receipt (EDR), International Depository Receipt (IDR) and Global Registered Shares (GRS).

Generally such a company’s primary listing is on a stock exchange in its country of incorporation, and its secondary listing(s) is on an exchange in another country. Cross-listing is especially common for companies that started out in a small market but grew into a larger market. For example, numerous large non-U.S. companies are listed on the New York Stock Exchange or NASDAQ as well as on their respective national exchanges such as Enbridge, BlackBerry Ltd, Statoil, Ericsson, Nokia, Toyota and Sony.

 

ind that a cross-listing on a U.S. stock market by a non-U.S. firm is associated with a significantly positive stock price reaction in the home market

show that companies with a cross-listing in the United States have a higher valuation than non-cross-listed corporations, especially for firms with high growth opportunities domiciled in countries with relatively weak investor protection

2014-12-20_23-55-10

 

 

Dual-listed companies should not be confused with cross-listed companies, where the stock of one company is listed on more than one stock exchange.

A dual-listed company or DLC is a corporate structure in which two corporations function as a single operating business through a legal equalization agreement, but retain separate legal identities and stock exchange listings. Virtually all DLCs are cross-border, and have tax advantages for the corporations and their stockholders.

In a conventional merger or acquisition, the merging companies become a single legal entity, with one business buying the outstanding shares of the other. However, when a DLC is created, the two companies continue to exist, and to have separate bodies of shareholders, but they agree to share all the risks and rewards of the ownership of all their operating businesses in a fixed proportion, laid out in a contract called an “equalization agreement.” The equalization agreements are set up to ensure equal treatment of both companies’ shareholders in voting and cash flow rights. The contracts cover issues that determine the distribution of these legal and economic rights between the twin parents, including issues related to dividends, liquidation, and corporate governance. Usually, the two companies will share a single board of directors and have an integrated management structure. A DLC is somewhat like a joint venture, but the two parties share everything they own, not just a single project; in that sense, a DLC is similar to a general partnership between publicly held corporations.

 

Some major dual-listed companies are listed in Category:Dual-listed companies; they include:[1]

Other companies were formerly dual-listed:

Some major dual-listed companies are listed in Category:Dual-listed companies; they include:[1]

Mispricing in DLCs

The shares of the DLC parents represent claims on exactly the same underlying cash flows. In integrated and efficient financial markets, stock prices of the DLC parents should therefore move in lockstep. In practice, however, large differences from theoretical price parity can arise. For example, in the early 1980s Royal Dutch NV was trading at a discount of approximately 30% relative to Shell Transport and Trading PLC. In the academic finance literature, Rosenthal and Young (1990)[2] and Froot and Dabora (1999)[3] show that significant mispricing in three DLCs (Royal Dutch Shell, Unilever, and Smithkline Beecham) has existed over a long period of time. Both studies conclude that fundamental factors (such as currency risk, governance structures, legal contracts, liquidity, and taxation) are not sufficient to explain the magnitude of the price deviations. Froot and Dabora (1999)[3] show that the relative prices of the twin stocks are correlated with the stock indices of the markets on which each of the twins has its main listing. For example, if the FTSE 100 rises relative to the AEX index (the Dutch stock market index) the stock price of Reed International PLC generally tends to rise relative to the stock price of Elsevier NV. De Jong, Rosenthal, and van Dijk (2008)[4] report similar effects for nine other DLCs. A potential explanation is that local market sentiment affects the relative prices of the shares of the DLC parent companies.

Because of the absence of “fundamental reasons” for the mispricing, DLCs have become known as a textbook example of arbitrage opportunities, see for example Brealey, Myers, and Allen (2006, chapter 13).[5]

SUMMARY
pick the company listing in the stronger economy 

pick the company listing in the country you will get a better tax advantage

 

One interesting finding by Froot and Dabora (1999) is that although the level of the premium or discount between twins may be hard to explain, it is possible to explain some of the changes in the price difference. In examining the cases of Royal Dutch Petroleum/Shell, Unilever NV/PLC, and SmithKline Beecham, Froot and Dabora find that prices of individual twins showed ‘excess comovement’ with the local stock market index in the country where most of the twins’ trading occurs. For example, the price of Royal Dutch was affected relatively more by developments in the US stock market (where it traded most actively, in the form of an ADR) while the price of Shell was influenced relatively more by movements in the UK stock market (where it traded most actively). Hence changes in the premium or discount between twins were partly explained by relative movements in the relevant national stock market indices. This finding has been widely interpreted as evidence that asset prices are 2014-12-20_23-32-42partly determined by the sentiment in the markets where trading occurs.

 

IBLN is a variation on a theme started by the Global X Guru Index ETF GURU, +0.92%  , which opened in 2012 and now has about a half-billion dollars in assets. The Guru fund tracks an equal-weighted index that attempts to mimic concentrated equity positions taken by large hedge funds, as reported in SEC filings; that’s the same basic concept as iBillionaire, but with 75 experts instead of 20 billionaires.

 

In 2013, the Guru fund was the top issue in its category, according to Morningstar Inc.

This year, it ranks dead last.

It hasn’t lost money — and it is still outperforming the S&P sharply since inception — but it’s pretty much in line with the average large-cap fund since it opened, despite one year of superior results.

 

But wait – how does it access such sensitive information? Well, as it transpires, everyone has access to the information already through SEC filings that are required for any investment made in excess of $100 million. What iBillionaire does is makes the data more easily accessible, while serving up historical trends – peaks and troughs – of how big investments fared.

 

(415) 659-9899
Dave Nadig

ETF.com Analyst Blogs

iBillionaire ETF Buyers: Beware Of Bear

Related ETFs: MOAT | GURU | IBLN
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It’s easy to be a cynic—in fact, I’ve been accused of either being a professional cheerleader or a professional cynic for most of my career (an odd dichotomy I still can’t figure out). And when someone launches a fund called the “Billionaire ETF,” it’s almost like someone showed up with a prewritten script for a late-night TV monologue.

But the thing is, the Direxion iBillionaire ETF (IBLN) is actually part of two waves of investing at the same time.

The first wave is the “smart” wave. We’ve seen a rash of “smart beta” launches, most based on models that algorithmically try to rebuild traditional pools of asset—like large-cap stock—using market-beating rules. But there’s another version of these smart products—the ones that are trying to tap other investors’ acumen.

The most notable example is the Global X Guru ETF (GURU | B-58). Guru builds a portfolio based on the filings of large hedge funds, as reported in 13F filings. It’s another snickerworth idea, but naysayers are really the ones who should be snickered at here: The fund has pulled in nearly $500 million in just two years, while crushing the S&P 500 by more than 22 percent.

But that’s not the only successful example: Van Eck launched the Market Vectors Wide Moat ETF (MOAT | A-48) in 2012 as well, based on the picks of the Morningstar equity analyst team, and it’s also beaten the S&P since its 2012 inception, by 4.56 percent.

IBLN takes things one step more active than either GURU or MOAT—it trolls through 13F filings for the personal holdings of the world’s wealthiest investors. The theory is, I suppose, that the 19 rich white guys they’re following all got at least the “rich” part from being smarter than the rest of Wall Street.

All three funds are really just vehicles for tapping a different kind of active management—one based on a “wise men” model rather than a hot-shot stock-picker model perhaps, and one that sticks the picks into an index before rolling them into a fund; but mostly, that’s splitting hairs.

The second wave all of these ETFs are part of, however, is the one I actually find more interesting: equal weighting. All three of the ETFs mentioned here take their best ideas from their different methodologies and equal-weight them, rebalancing occasionally.

Equal weighting is the simplest-to-implement version of the “anything but market cap” approach to smarter investing, and despite the implied higher trading costs, it’s actually been a consistent winner during this bull market.

Consider the returns just of the Guggenheim S&P 500 Equal Weight (RSP | A-79) versus the SPDR S&P 500 (SPY | A-98):

RSP_SPY

That’s a nearly 20 percent gain over the naive S&P 500 in five years.

Now, there are lots of academic reasons why equal weighting has outperformed—it’s not magic. It’s overweight smaller-cap stocks, which have juiced its beta by about 8 percent. That increased beta means it goes up more when the market is up and down more when the market is down. We’ve been mostly in an up market. It’s not a free lunch—it’s a tool to tweak your exposure.

So let’s consider how these other equal-weighted, “wise men” focused funds have done (substituting in indexes where the actual fund history isn’t long enough).
manyfunds

Charts courtesy of Bloomberg

You’re starting to see the appeal of “anything but market cap” in a bull market. Every one of these strategies beat the pants off the S&P 500 over the five-year window, with iBillionaire on top. I don’t find that particularly surprising—the index was only introduced in November last year, and let’s be honest, nobody has ever introduced a “smart” index that looks bad on the backtest.

But I’m left with more than one concern:

The first is simply that I remain, as always, enormously skeptical of active management. IBLN certainly looks good on paper right now, but it hasn’t actually been tested in a live bear market.

And the thing you’d expect these “wise men” to do if they were really geniuses managing your money would be to get out of a falling market faster than everyone else—precisely what IBLN cannot possibly do, since it’s dealing with data lagged from these gentleman by 45 days through the 13F filing process.

The second is that I’m not convinced folks will understand that a significant portion of the “magic” here comes from simply equal weighting a large-cap portfolio. That magic serves mostly just to boost the beta of the underlying selection of stocks.

That works great in upmarkets, and can really hurt in downmarkets. In the terrible year leading up to the March bottom in 2009, for instance, equal-weighted S&P underperformed the S&P by an extra 5 percent—rough justice in a period where the S&P was down 45.5 percent already.

My prediction, however, is that despite all the snickering, we’ll continue to see strong flows into IBLN, GURU and their inevitable copycats. No matter how many regressions I run, or how many statistics I can trot out, nobody wants to be average, and the belief that the rich guys must be smart is so fundamentally American that it’s an easy sell.

At least when the market’s up.

 

Why is the Government Buying Long-Term Bonds?

By Alejandro Reuss

I heard that the government is now buying long-term bonds. What’s that all about?

Basically, the government is purchasing long-term bonds in order to push down long-term interest rates. (While the Federal Reserve is buying both government and private bonds, here we will focus just on purchases of government bonds.) The reduction in long-term interest rates, in turn, is meant to stimulate investment and other forms of spending.

Wait a minute. Don’t banks decide what interest rates to charge—like on business loans, home mortgages, car loans, or whatever? How would the government force banks to charge the interest rates that the government wants? And what does buying bonds have to do with it anyway?

Those are all good questions. Let’s start with how the government influences interest rates.

When we hear about government policies designed to change the money supply or influence interest rates (monetary policy), we are talking about the role of the Federal Reserve (or “the Fed”). This is the central monetary-policy making authority for the United States.

The main way that the Fed influences interest rates is by buying and selling government bonds. It decides whether to increase or decrease interest rates depending on whether it aims to pump up or rein in overall demand for goods and services. When Fed policymakers decide that they want to raise interest rates, the Fed sells government bonds. This sale reduces the price of bonds and raises the interest rate on these bonds. (We can also think of this as the Fed reducing the money supply. This makes money less plentiful and drives up the price of borrowing.) When Fed policymakers decide they want to lower interest rates, the Fed buys government bonds. This purchase increases the price of bonds and lowers the interest rate on these bonds. (We can think of this as the Fed increasing the money supply, which makes money more plentiful and drives down the price of borrowing.)

Usually, the Fed buys and sells short-term government bonds in order to change a very short-term interest rate called the “federal funds rate.” Now, the Fed is buying and selling longer-term government bonds, with the aim of influencing longer-term rates.

When the Fed buys government bonds, does that just mean paper is shuffling back and forth between one part of the government and another?

No, the Fed buys bonds previously sold by the U.S. Treasury to “members of the public” (to some extent to individuals, but mostly to financial firms, in the United States and abroad) and to the central banks of other countries.

When the government needs to borrow, the U.S. Treasury sells bonds. (A bond is basically an IOU, the government’s promise to pay the owner of the bond a certain amount of money at a specific date in the future. In the meantime, the government can spend the money it received in exchange for the bond.) At any time, there are lots and lots (and lots) of bonds owned by people or institutions who have either bought them directly from the Treasury, or bought them from someone else in the “bond market.” Bonds may change hands lots of times after their initial sale by the Treasury. When the Fed wants to lower interest rates, it buys some of these bonds from their owners.

You said that when the bond price goes up the interest rate goes down, and vice versa. Why do the bond price and the interest rate move in opposite directions?

That’s a good question. Suppose that you can buy a bond today for $100 and it promises you $110 in a year. The interest rate is the difference between what you will get and what you paid ($110 – $100 = $10), divided by the purchase price ($100). That comes to 10%. Suppose the purchase price for that bond increases to $105, but it still promises $110 in a year. Now the difference between what you get and what you paid is only $5. Divide that by the purchase price ($105), and you get an interest rate of less than 5%. So when the bond price goes up, the interest rate goes down. (It works just the same in the opposite direction.)

More demand for bonds (including demand from the Fed) means a higher bond price, and that pushes down interest rates. So when the Fed wants to push interest rates down, it buys bonds.

OK, so the Fed can push down the interest rate on government bonds, but how does that push down interest rates that banks charge and consumers or businesses pay?

Imagine a bank deciding to whom to lend. The bank can lend to the government (by buying government bonds), or it can lend to private businesses, to individuals, and so on. If the risk of lending to one borrower is the same as the risk of lending to another, the bank will make whichever loan fetches the higher interest rate.

The U.S. government is a very safe borrower, so much so that government bonds are considered “risk free.” Let’s set risk aside for now, and assume that there are other borrowers that are just as safe as the U.S. government. Suppose that the interest rates on government bonds and these very safe borrowers’ bonds are both equal to, say, 2%. So the bank can buy either bond for $100 today and be promised $102 in a year.

Suppose the Fed starts buying government bonds, and that makes the bond price go up to almost $101 (pushing the interest rate on government bonds down to 1%). Let’s think about what the bank will do now. Suppose that it had just paid $100 for a government bond that promises $102 in a year. The bank can hold onto that bond and still get $102 in a year. But it can also sell the bond for $101 and buy a private company’s bond for $100. The private company’s bond still promises $102 in a year, but the bank, having sold a government bond for $101 and bought a private bond for $100, also gets to pocket the difference of $1. If the bank were to sell 100 government bonds, it could buy 100 private-company bonds, plus use the extra $100 it pocketed to buy one extra bond. A bank that wants to make as much profit as possible, then, will sell the government bonds it holds and buy private-company bonds.

If banks start buying private-company bonds (with the money they made by selling government bonds), then the price of private-company bonds will go up and the interest rate on those bonds will go down. In other words, private companies will now be able to borrow at a lower interest rate than before.

So how low will interest rates for private companies go?

If the risk on private-company bonds were the same as on government bonds, as we assumed in our example, then the process would continue as long as the interest rate on the private bonds remained higher than that on the government bonds. The two would eventually end up equal.

In reality, however, the risk on a loan to a private company (even the most rock-solid) is greater than the risk on a loan to the U.S. government. When lending to a private company or individual (or, for that matter, to state or local governments, or national governments deemed less credit-worthy than the U.S. government), lenders insist on a higher interest rate to compensate them for the greater perceived risk. The difference in interest rate between a risky loan (like a business loan, home mortgage, car loan, etc.) and a “risk-free” loan (as to the U.S. government) is called the “risk premium.”

If the risk premiums between different loans (to different borrowers) do not change, then lowering the interest-rate on a risk-free loan will lower the interest-rate on risky loans by the same amount. You can think of different interest rates, associated with different levels of risk, as being “stacked” on top of each other. The idea behind Fed policy is that, by lowering the interest rate on the bottom of the “stack,” the interest rates above it will also come down. In real life, the “spreads” between interest rates may increase, especially during a crisis, when investors are desperately looking for safe places to park their money. So the interest rates on top of the stack may not come down as much as the interest rate on the bottom.

Why does the Fed want to bring down interest rates now?

The idea is that lower interest rates encourage people and companies to spend, adding to demand for goods and services and stimulating production and employment.

Economists especially emphasize the relationship between interest rates and investment spending. In this context, “investment” means the purchase of highly durable goods, like machinery, new factories and office buildings, and new houses (not purchases of stock or other “paper” assets). When companies make investment decisions, they decide whether the cost of buying new factories or new machines is justified by the expected profits from the sale of goods (made with those factories or machines). The idea behind government policies to lower interest rates is that some projects that would not have been profitable for a company at a higher interest rate would be profitable at a lower interest rate. So, if the government can bring down interest rates, companies will undertake some projects that they would not have otherwise, increasing production and employment.

Hasn’t the government been bringing down interest rates for a couple of years now? Why keep on doing the same thing if it’s not working?

Yes, the Fed has brought interest rates down in response to the current economic crisis. As mentioned earlier, during a recession the Fed usually buys short-term government bonds, which has the effect of driving down short-term interest rates. The Fed usually targets a certain level of the “federal funds rate,” the interest rate that banks charge each other on very short-term (overnight) loans. The federal funds rate has basically been 0% for a couple of years now.

There are a couple of problems with this policy:

First, the interest rates that the Fed directly targets are not directly relevant to the decisions made by businesses and households. Neither businesses nor families can typically borrow at the same rates that banks can. Moreover, long-term interest rates are usually more important to businesses and individuals than very-short-term rates. When businesses buy factories or expensive machinery, or people buy cars or houses, they usually take out loans for five, ten, twenty, or thirty years (certainly not overnight).

Second, once the government has pushed the federal funds rate to 0%, it cannot go any lower. If that’s not enough to stimulate substantial new spending and pull the economy out of a recession, there’s nothing more that the government can do using “conventional” monetary policy (that is, a policy that focuses on short-term rates).

This is why the Fed is now turning toward policies aimed at bringing down longer-term interest rates.

If the Fed keeps this up, isn’t it going to cause runaway inflation?

The U.S. economy is currently operating far below capacity. There are about 15 million unemployed workers, plus millions more who are working part-time but want full-time jobs. This is not at all like a situation where the economy is already operating close to full capacity. Under conditions of full employment, additional demand cannot result in more goods being produced. Instead, prices are bid up, causing inflation. When there is lots of excess capacity, however, more demand can result in increased production of goods and services. Even though demand has increased, so has supply, so prices need not increase (at least not very much).

Even if the inflation rate were to increase a bit, that would not be such a bad thing.

First, the current inflation rate is very low. The risk right now is deflation, a decrease in the general price level. If people expect prices tomorrow to be lower than prices today, they tend to put off purchases. For this reason, deflation would exacerbate the depressed demand that is causing high unemployment. In addition, deflation means that people’s money incomes decline. (People’s incomes are largely based on prices of one kind or another, so as prices fall across the board, so do people’s incomes in dollar terms.) Their debts, however, stay the same. So deflation would make real debt burdens larger.

Low-income people tend to be net debtors (to owe more than they are owed) and high-income people tend to be net creditors (to owe less than they are owed). Therefore, deflation has the effect of redistributing income from low-income people to high-income people. People with low incomes also tend to spend all or almost all of their incomes, while people with high incomes tend to save more of their incomes. If income is redistributed from people who would spend it to people who would save more of it, overall spending will decrease. So deflation, by redistributing income from debtors to creditors, would likely reduce overall spending.

Second, just as deflation would depress spending now, modest positive inflation would encourage spending now. If people expect that prices tomorrow will be higher than prices today, they will tend to spend now, rather than put off purchases. Given widespread fears of unemployment and reluctance to spend, this effect will not, by itself, pull the economy back to full employment, but it would probably boost spending somewhat. A bit of inflation would also reduce real debt burdens.

I’ve also heard that the policy will weaken the dollar. Is that true?

This policy is, indeed, likely to “weaken” the dollar. This means that the same number of dollars would buy fewer units of another currency, like the euro (€).

A weaker dollar means that goods produced in other countries will become more expensive in terms of dollars. Suppose you want to buy a t-shirt that sells for 10€. If you can get 10€ for $10, then the t-shirt costs you $10. If the dollar weakens against the euro, and now you can only get 10€ for $11, the same 10€ T-shirt now costs you $11. This effect would cause domestic prices to increase as well, since domestic producers would face less international competition. While this contributes to inflation, remember that a bit of inflation would not be all bad, for the reasons described above.

A weaker dollar also has the effect of making goods produced in the United States cheaper to people in other countries. If someone in Europe can get $10 for 10€, then they can buy a $10 t-shirt for 10€. Suppose the dollar weakens against the euro, and now they can get $10 for 9€. This means that the European buyer can get the same $10 t-shirt for 9€. This increases demand for U.S. exports—and that extra export demand, just like extra domestic demand, tends to increase U.S. output and employment.

A weaker dollar, by making U.S. exports cheaper for buyers in other countries and those other countries’ exports more expensive in the United States, could mean less demand for goods produced in other countries (and therefore reduce output and employment in those countries). Remember that the policy is also intended to boost overall U.S. demand for goods, which would tend to increase U.S. demand for imports. It’s not clear whether the exchange-rate effect or the demand effect would be larger, so we can’t say for sure that the policy would reduce demand for goods produced in other countries. Nonetheless, the governments of Germany and China have criticized the Fed’s plan, evidently fearing the effects on their trade balances, and on employment in exporting industries.

U.S. politicians and the mainstream media often talk about boosting the U.S. trade balance (reducing the trade deficit, or bringing about a trade surplus) as if it were obviously a good thing. One’s conclusion about whether it would be good or bad, however, depends on whether one thinks that increased employment in the United States—even at the expense of employment in other countries (even much lower-income countries)—is a good thing or not.

OK, is this new strategy likely to work?

There are major problems.

First, it’s not clear how effective the policy will be at lowering long-term interest rates. The Fed has increased the money supply dramatically over the last few years. Banks have sold bonds to the Fed and received cash in return. The Fed’s idea was that the banks would try to loan out as much of that money as possible, lowering the interest rates they charged in order to find new borrowers. In fact, however, banks have held onto much of that money in the form of “excess reserves” (over and above the amount they are required to hold by law). Uncertain about the value of assets they held (especially those related to home mortgages), banks held on to reserves as a hedge against the risk of insolvency. It’s possible that the new infusion of money into the banking system will, likewise, remain in banks’ coffers.

Second, it’s not clear that lower interest rates (even long-term rates) would have much of an effect on investment demand. Remember, investment means purchases of highly durable goods, like machinery, new buildings (including new housing), and so on. Right now, businesses still have negative expectations of future sales, and so are not trying to increase output very quickly. Moreover, they have vast amounts of excess capacity—meaning shuttered buildings, unused machinery, and so on. Under such conditions, lower interest rates are not very likely to entice businesses to run out and buy new plant and equipment. New construction of residential housing is even less unlikely to resume soon, given the excessive construction during the housing boom and looming foreclosures, which will dump enormous numbers of existing houses on the market.

If this won’t work, is there anything that might?

One possible answer is another round of fiscal stimulus. In contrast to the policies discussed above, which involve changes in the money supply and interest rates and are therefore termed “monetary” policies, “fiscal” policies involve changes in government expenditures and taxes. A fiscal stimulus involves increased government expenditures or decreased taxes, with the idea of boosting demand, and therefore output and employment.

It’s not that the first fiscal stimulus “didn’t work,” and that the government should try the same thing while expecting a different result. The first stimulus was way too small—as serious economists pointed out at the time. It did not create nearly enough demand (through increases in spending and reduction in taxes) to counteract the collapse in private consumption and investment, as well as the decline in state-level spending.

Some fiscal policies that make sense now include: 1) Increases in unemployment insurance payments (making payments more generous and extending their duration). Unemployment insurance both provides some relief to the unemployed and helps boost demand, since unemployed people are likely to spend all or nearly all of their benefits. 2) Federal government grants to prevent state budget cuts. Budget cuts at the state level are not only eliminating essential services, but also reducing demand, both directly and indirectly (by putting people out of work, which causes them to cut back their spending as well). 3) Additional government spending on real goods and services. Some obvious possibilities would be infrastructure investments, like renovations of school buildings, public housing, and so on. Investments in alternative energy (such as windmills or solar energy) and new transportation systems (like high-speed rail) could not only boost demand now but also plant seeds for new “green” technologies and industries. 4) Direct government hiring, like under the Works Progress Administration (WPA) and other “alphabet soup” programs during the Great Depression.

None of these things is theoretically very complicated. If they seem unlikely now, which they are, the reasons lie in the distribution of political power, rather than any inherent mystery about our predicament or what can be done about it.

When the Federal Reserve (Fed) raises or lowers interest rates a chain reaction is set into motion. It’s like the domino effect. The Fed is the first domino and whatever they do — creates the chain reaction. If the fed raises interest rates, banks raise their prime rate, which in turn affects mortgage rates, car loans, business loans, and other consumer loans. However, a bank can raise or lower their prime rate without the FED making the first move. It is uncommon for most banks to change their prime rate without the fed making the first move — but it does happen.

Lower interest rates usually spur the economy by making corporate and consumer borrowing easier. Higher interest rates are intended to slow down the economy by making borrowing harder.

Think about it this way: If interest rates increased from 6% to 14% what do you think would happen in the area of home mortgages? Naturally, less people would be buying or building homes, and the sale of building supplies would decrease. Make sense? If interest rates decreased from 14% to 6% what do you think would happen? People would be storming the banks in a rush to borrow “cheap” money to build new homes, buy cars, and invest in their business.

Let me define a few of the common terms used in the media:

1. Federal Funds Rate: The interest rate (controlled by the Fed) which banks charge each other on overnight loans. This is usually the rate that the Fed keeps adjusting.

2. Discount Rate: The interest rate charged by the Fed on its own loans to banks.

3. Prime Rate: the interest rate banks give their best customers and has a direct effect on other rates for mortgages and car loans. When the Fed raises or lowers the interest rate, most banks follow by changing their prime rate. Some respond by raising their prime rates only minutes after the announcement.

4. Inflation: Inflation takes place when you have to spend more money to buy services or goods — than you used to. Inflation takes place when you have too much money chasing after too few goods! The Fed raises and lowers interest rates to help keep inflation under control. Restricting the amount of money available to people is one tool the Fed uses to keep inflation under control.

Let me illustrate the most common effects of the Fed changing interest rates:

When the Fed RAISES
Interest Rates You Can “Expect”
When the Fed LOWERS
Interest Rates You Can “Expect”
Prime Rate HIGHER LOWER
Mortgage Rate HIGHER LOWER
Car Loan Rate HIGHER LOWER
CD Rate HIGHER LOWER
Money Market Rates HIGHER LOWER
Credit Card Rates HIGHER LOWER
Stock Market LOWER  HIGHER
Business Profits LOWER HIGHER
Consumer Spending LOWER HIGHER
Home Sales LOWER HIGHER
Borrowing LOWER HIGHER

 

Common Questions:

Why does the Fed lower or raise rates?

The Fed is trying to maintain a “healthy” economy. If the economy is “very slow” the Fed might decide to lower interest rates that will in turn make money more available to businesses, home buyers, and consumers. If the economy is “heating up” and in the opinion of the Fed — growing too quickly, they will raise interest rates to “slow things down”.

The Merry-Go-Round Illustration

Merry-go-rounds are fun to ride if they are going the right speed — not too slow or too fast! Imagine that a merry-go-round represents our economy. Imagine with me the Fed represents the person at the controls of the merry-go-round. If the merry-go-round is going too slow, it‘s the job of the Federal Reserve to help pick up the speed by moving a few levers (interest rates would be one example) so that the maximum number of people can enjoy the ride.

If the merry-go-round is moving too fast, it’s the job of the Federal Reserve to move a few levers, gently applying the brakes and help slow it down. If the merry-go-round is going too fast some people might be enjoying the ride — but eventually people are going to start getting sick — be thrown off the ride — have to go to the hospital — and some might die. Plus, the machinery running the merry-go-round might begin to overheat and eventually stop working. If that happens no one will be able to enjoy the ride anymore!

In merry-go-round terms — it’s the job of the Federal Reserve Board to give the majority of the people a pleasant ride. Not everyone will always be happy. Some will want to keep the ride going fast, others like it slow, but the role of the Federal Reserve is to do what is best for the overall economy.

What is the goal of the Federal Reserve?

The Federal Reserve was commissioned to be sure our banking system remains sound and to keep our economy healthy. The Fed tries to keep our economy from experiencing boom and bust “extremes”.

Why Is “Rapid Growth” Not Good For The Economy?

Steady growth is good! But too much growth “too fast” is not good. I have thought for a long time about how to explain this. Let me try it this way:

You own an ice cream business. On an average business day you have about 200 customers coming to your store buying your ice cream. One morning you show up and 2000 people are standing outside your door wanting to buy ice cream. After your initial panic and excitement, you and your one employee begin serving the customers. By mid-morning you have even begun the process of ordering additional ice cream to be delivered by an express ice cream truck. Because of the long line, some of your ice cream customers will be mad and leave, but you faithfully keep serving those in line.

You think to yourself, “Life is great and the ice cream economy is booming!” In fact, for the next seven days, 2,000 people are standing in line to buy your ice cream. Due to the high demand, increased expenses and the obvious ample supply of money in your community, you decide to raise the price. This is what we would call inflation. You have inflation when too much money is chasing after too few products. Remember, inflation is one of the things the Federal Reserve is trying to avoid.

Let’s say next week the demand for ice cream is back to normal, about 200 people a day. What if you had already put on the payroll eight more employees to serve your customers? What if you had increased your ice cream order 10 times the normal amount? What if the ice cream supplier had already delivered your ice cream? What if you had already signed a new lease to triple the square footage for your ice cream store?

With the decrease in demand for ice cream, the only thing you could do would be to start handing out pink slips to several of your employees. You would also have to deal with a massive surplus of ice cream in your storage. In addition, you would have a large amount of your money tied up for a long time in inventory because it might take you months to sell all the ice cream you ordered.

In simplistic terms, this is exactly what the Federal Reserve is trying to avoid. They are controlling the availability of money by raising and lowering interest rates so that 2000 people will not show up at your ice cream store. The Fed and you would rather see “steady growth”.  And steady growth (not rapid growth) is good for the economy!

Who appoints the Federal Reserve Board Members?

Congress established the Federal Reserve in 1913. The Board of Governors has seven members who are nominated by the President of the United States. The Senate confirms the nominations and each board members serves for a 14 year term. The chairman is appointed by the President, confirmed by the Senate and serves a four year term, and can be re-appointed.

What is the Federal Open Market Committee?

This committee meets eight times each year to adjust (if necessary) the federal funds rate and the federal discount rate. It is made up of the seven board members, the president of the Federal Reserve Bank of New York, and four other presidents (from the other 11 Federal Reserve Banks).

In these meetings they discuss trends in: housing, inflation, wages, employment, construction, inventories, business investments, foreign economic issues, consumer income, consumer spending and interest rates.

After discussion they decide if interest rates or economic policies need to be adjusted so that the economy remains stable and people are enjoying the ride! As mentioned earlier, the most common adjustment is to change the Federal Funds Rate: the interest rate which banks charge each other on overnight loans.

Is the Federal Reserve Controlled by the Government?

The Fed is commissioned by Congress, but is independent in its decision making policies. The Fed was not designed to be a political tool, therefore it has to be independent from the government. Yet, Congress can change how it operates at any time! The chairman gives reports and answers questions to Congress twice a year.

Summary

It is the responsibility of the Fed to implement policies that will help to maintain good economic health for our country. One of the primary tools the Fed uses is interest rates — which have a direct impact on the direction of our economy. Decreasing interest rates will cause economic growth and increasing interest rates will cause the economy to slow down.

A Biblical Perspective

Some of you might be thinking, “Why do I need to understand what happens when the Fed raises or lowers interest rates? Who cares?” As a steward and manager over the financial resources God has entrusted to you — you should care! For example, the overall direction of our economy affects the return on your investments, your potential for charitable contributions, and if you have a mortgage payment, how much you are paying each month. Developing an overall understanding of the economy will be beneficial in making financial decisions. Don’t be like the servant who was lazy and went out and buried his talent (Matthew 25). Seek to understand the economy in which you live. Seek to properly invest the resources God has entrusted to you. Seek to avoid having to pay higher interest. Seek to have a basic knowledge of how interest rates work and how the stock market works. Seek to be a good and faithful steward!

Constructing a Candlestick Chart

Four pieces of data, gathered through the course of a security’s trading day, are used to create a candlestick chart: opening price, closing price, high, and low. The candle in a chart is white when the close for a day is higher than the open, and black when the close is lower than the open. The wicks, lines sticking out of either end of the candlestick, represent the range between the day’s high and low prices. The wick on top shows the day’s high, the wick on the bottom shows the day’s low.

image0.jpgAdditional information is sometimes displayed with candlestick charts. Don’t be afraid to use it! The following types of information are commonly included on candlestick charts and can be very useful in your analysis:

  • Volume: The total number of shares or contracts trading during a time period.

  • Open interest: The total number of open contracts on a futures product.

  • Moving averages: Lines that represent the average closing price for a time period and a few periods in the past.

  • Technical indicators: Statistics that can be displayed in a variety of ways on a chart.

  • Fundamental information: Data that includes dividend dates, days of share splits, or even insider buying and selling!

13:30 USD Consumer Price Index Ex Food & Energy (YoY) High 236.151 236.369 237.433
CPI assesses changes in the cost of living by measuring changes consumer pay for a set of items. CPI serves as the headline figure for inflation. Simply put, inflation reflects a decline in the purchasing power of the dollar, where each dollar buys fewer goods and services. In terms of measuring inflation, CPI is the most obvious way to quantify changes in purchasing power. The report tracks changes in the price of a basket of goods and services that a typical American household might purchase. An increase in the Consumer Price Index indicates that it takes more dollars to purchase the same set basket of basic consumer items. Inflation is generally bad news for the economy, causing instability, uncertainty and hardship. To address inflation, the Fed may raise interest rates. However, the Fed relies on the PCE Deflator as its primary gauge of inflation because the CPI does not account for the ability of consumer to substitute out of CPI’s set. Price changes tend to cause consumers to switch from buying one good to a less expensive-other, a tendency that the fixed-basket CPI figure does not yet account for. Given that the PCE Deflator is a more comprehensive calculation, based on changes in consumption; it is the figure the Fed prefers. The figure is released monthly, as either a month over month annualized percentage change, or percentage change for the full year. The figure is seasonally adjusted to account seasonal consumption patterns. On A Technical Note: The CPI includes over 200 categories of goods and services included, divided into 8 main groups, each with a different weight: Housing, Transportation, Food, Medical Care, Education and Communication, Recreation, Apparel, and Other Goods and Services