Wealth Building Lessons

On Tuesday, Ben Bernanke cut the Federal Funds rate by 50 basis points (or 0.5%) to 4.75%. While most people may not have expected a cut of this magnitude, they definitely were expecting some sort of rate cut. There’s been too much bad news regarding the economy to think otherwise.

Job growth is down, employment figures are getting worse, inflation is increasing, consumer spending has dropped off, the GDP is near-zero but mainly the US homeowner and the mortgage industry is suffering from rising mortgage rates and falling property values. Mortgage lenders have been dropping like dead flies, with 159 currently having shut down since December 2006 (source: Mortgage Implod-o-meter.) Scared that Countrywide (CFC) would face insolvency, there was even a bank-run on its banking branches in Southern California. On top of that there’s a war thats costing us nearly $3 Billion per week and Tim Paulson asking Congress to raise the Federal Debt Ceiling to $9.5 Trillion. (Thats a 1 followed by 13 zeros!).

I don’t know about you but I really don’t have a lot of faith in the economy right now.

One of the main reasons we’re in this mess is because the Federal Reserve kept interest rates artificially low (the Federal Funds rate was at an unbelievable low of 1.00% between July 2003 and May 2004) and in order to prevent a minor recession, stimulated the economy through excess liquidity (which basically means they’re printing more money). Unfortunately, as history has proven numerous times before, cheap and easy money often leads to wild speculation and asset bubbles.

By dropping the interest rates, the Fed has signaled that he’s willing to prop up the economy and prevent it from going into recession. Isn’t it strange how the problem and the solution are both the same!

However, dropping the interest rates has a negative effect on how foreigners perceive the US Dollar. Money typically flows where its treated best, namely to strong economies where the government bonds pay a high rate of interest. The US government treasury bonds or T-bills currently yield around 4.5%. According Bill Gross, Bond Fund manager at PIMCO Funds, the Fed is likely to cut the Federal Funds rate down to 3.75% which means the T-bills will probably follow suit and yield less than they’re yielding today.

As soon as the rate cut was announced, the Dollar promptly dropped against almost all major currencies, oil spiked higher and so did the price of gold. Today the Canadian Loonie achieved parity with the US Dollar after a gap of 30 years, both the Euro and Oil are at all time highs and Gold is the highest since 1980. These moves are likely to continue as the Feds keep cutting the interest rates.

A depreciating Dollar will also make the sale of US Treasuries more difficult, which is important because the foreign governments who buy a majority of the T-bills or Federal Debt, are essentially financing the government spending. If they think their investments will be worth less on maturity, they will not be eager to fund our growth.

So why did Bernanke cut the rates so much? Probably to prevent a bank-run similar to what happened in England. This week, England’s 5th largest lender Northern Rock experienced a good old fashioned bank-run. People expecting Northern Rock to become insolvent camped outside overnight.

The Bank of England had to step in and promise to provide liquidity to Northern Rock. So probably, rather than face similar bank-runs and cause a global panic over the state of the US economy, Bernanke thought it better to lower the interest rates and open the federal discount window (so banks can easily borrow money). Another thing to consider is that banks typically borrow short-term and lend out long-term. This is not a good business model if rates are rising. So lowering the interest rates improves the banks profit margins, especially if they’re hurting from making bad loans to begin with.

So how does this affect the average American?

Well mortgage rates have actually crept up since the past week (source: Bankrate.com (RATE)). Rates typically move in anticipation of Fed so if they think the Fed isn’t going to cut rates any more, the rates might move up. Also, since the subprime debacle and 2 of Bear Stearns’s hedge funds going under, there has been a repricing of risk. Its becoming increasing difficult to sell mortgages on the secondary market and so rates might increase due to the additional risk. In other words, no one really knows how mortgage rates will be affected.

However, Home Equity Lines of Credit (or HELOCs) are usually tied to Prime, which just dropped 0.5% which means your HELOC rates should drop. Also business loans and credit card rates are also tied to the Prime rate, which means that those loans just got cheaper too!

Maybe the Fed is hoping that lower interest rates will fuel consumer spending again, which happens to be an awfully large part of our GDP. (True wealth is not achieved through consumer spending, its attained through production and manufacturing. Which is why China has enough wealth to become the biggest lender to the US, which is pretty much insolvent)

On the flip side, interest rates in savings accounts and CDs will drop. This negatively affects people living off their savings. It also affects everyone who saves money, since inflation will erode the value of your savings significantly over the long term.

One way to hedge against the falling Dollar is through investments in foreign currencies, precious metals, commodity/mining stocks, foreign stocks and Canadian royalty trusts.

How are you going to profit from the devaluing Dollar?

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