The Fed, Low Interest Rates, and YOU

As I’ve mentioned in my QE3 piece last Saturday, conditions in the U.S. markets have taken a turn for the worse. And with the Jackson Hole meeting only a few days away, market participants are at the edge of their seats wondering what the Fed will do next.

For those who are wondering what the heck is a Jackson Hole meeting, it’s an annual assembly of central bankers, finance ministers, and other major market participants in Jackson Hole, Wyoming.

The Fed

Right now market analysts are asking: “Does the Fed have any more tricks to pull from its sleeve?” Recall that the central bank already has already had its interest rates near zero since December 2008. What’s more is that it already shelled out around $1.7 trillion between December 2008 to March 2010, and another $600 billion from November 2010 to June 2011 to buy Treasuries and mortgage debts.

Jackson Hole meeting

This time around markets are closely looking to see if the Fed plans to introduce more economic stimulus. After all, it was this time last year when Big Ben hinted at QE2, which sparked the S&P 500’s 28% rally over the next few months.

Unfortunately for the U.S. economy, many believe that the Fed’s latest interest rate decision is all the action we’ll get, at least for the next couple of months. Early this month the Fed announced its plan to keep rates between 0.00% and 0.25% until mid-2013, even though three Fed members stepped up to oppose the plan.

Unless the Fed introduces new measures to stimulate the economy, the U.S. economy will only have low interest rates to work with. So how will this affect market participants?

Low Interest Rates

Banks
Low interest rates, at a time like this, can be bad for a bank’s bottom line. You see, one of the many ways banks turn a profit is by borrowing money at short-term interest rates and lending out money at higher long-term rates. I’m sure by now you’re familiar with carry trades; it’s basically the same concept!

The problem lies in that short-term interest rates have been fairly steady while long-term rates have been sliding. So banks are borrowing money at more or less the same rates, but they’re lending it out at lower rates, putting a squeeze on their profits. As a matter of fact, banks’ yield on assets, which is a measure of how much money banks make given their resources, fell to 4.41% in Q1 2011, its lowest
level in six years!

Companies
As for companies, low rates means easy money… at least for some. Companies in need of raising funds will surely appreciate lower rates as it makes borrowing cheap. However, those with lots of cash sitting in banks will probably frown when they see that they aren’t making as much on their deposits as they used to. Also, businesses like insurance companies and pension funds are probably having a hard time making money right now, considering they invest most of their clients’ premiums in bonds and other fixed-income instruments.

You and I

Just like with companies, low interest rates are good for some and bad for others. For those looking to borrow money, it’s good news. Low rates means easy and cheap money for borrowers, which means now’s a good time to loan money if you’re considering buying a new house or a new car (the new Chevy Camaro is H-O-T!).

On the flipside, it’s bad news for retirees and those who rely on fixed-income investments, as low interest rates translate to lower interest income.

The Fed has pretty much exhausted its bag of tricks, and interest rates are already about as low as they’ll ever get. The question on everyone’s minds right now is, what else can the Fed do? Will the Fed surprise the markets by buying additional securities? Will it increase the maturity of its bond portfolio? Will it lower interest rates on excess reserves?

Well, whatever the case may be, we won’t have to wait long to find out. The Jackson Hole meeting is just a few days away. All questions will be answered on Friday… hopefully.