DECEMBER 2018 may be remembered as the month that the Dow (Dow Jones Industrial Average index) turned in its worst performance since October 2008. The Dow is currently down about 14 percent, almost the same as in 2008. Santa Claus left large chunks of coal in the Christmas stockings of holders of US stocks.
The US Federal Reserve is being blamed for the massive drop in share prices because the Federal Funds interest rate in the US has been raised four times in 2018. In the US, the federal funds rate is the interest rate at which banks lend reserve balances to other banks overnight.
The definition does not really tell us much about how the system works. Banks buy US government debt to park some of their cash as required by law. The Fed then buys that debt from the banks to put more money into the economy.
Since 2009, the Fed has put about $4.5 trillion into the economy through this system of “buying.” But the key is that all interest rates in the US are based on the Fed fund rate. Since 2009, this base interest rate has been almost zero.
On December 14, 2016, the Fed Open Market Committee raised the Fed funds rate to 0.75 percent, from 0.50 percent. Consumers and businesses also saw their borrowing rates increased.
On June 14, 2017, the Fed decided that it would no longer continue to buy government debt from the banks. The Fed also doubled the Federal Fund rate to 1.5 percent.
In 2018, interest rates continued to be raised to the current 2.5 percent. Therefore, interest rates first tripled in 2017 and then increased another 67 percent in 2018. But it is important to note that even with rates tripling in 2017, the Dow went up 30 percent. Yet, in 2018 the Dow was basically unchanged for the year as of the end of November.
Since the end of November 2018, the Dow has been down about 15 percent.
If the increasing interest rates are the reasons for the Dow “disaster,” then why didn’t the tripling of rates in 2017 cause the same problem, and why is it only in the past month that the Dow has gone down so much?
One reason is that economic growth continued to trend higher in 2017. There is a fear that the growth rate has leveled out. However, that is speculation with only limited evidence to support the conclusion. But spending and investing money is as much a psychological decision as it is financial.
As I mentioned before, my Tang Four Seasons powder drink mix effectively doubled in price this year. While I can afford the extra cost of P100 a month, I have decreased my purchases by half. Psychologically, I cannot accept the increase in price.
When, in a few months, the Philippine inflation rate goes back to a “normal” 2-4 percent, I may change my mind. Likewise, unless the US economic growth does trend down in the next two quarters, the Dow may also adjust to higher interest rates and continue its long-term uptrend.
Similarly, the local Philippine stock market stopped going down in October when investors started to believe that our inflation rate had peaked.
Also, since September, the prices of crude oil, cryptocurrencies and commodities including copper, cotton, lead, potatoes, rubber and corn have all seen large declines. Can this be directly attributed to the last two Fed rate increases from a financial viewpoint? No it cannot. But psychologically, the Fed created a wave of near panic.
E-mail me at mangun@gmail.com. Visit my web site at www.mangunonmarkets.com. Follow me on Twitter @mangunonmarkets. PSE stock-market information and technical analysis tools provided by the COL Financial Group Inc.