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We have been seeing a lot of speculation on how the rates would be cut by the US Federal Reserve (FED) in their July meeting. Will it be 50bps or 25bps? Yesterday, the Fed announced first rate cut of 25 basis points in over a decade. The US is the world’s biggest economy and thus it has global implications.
But you may now be wondering how to explicate this recent rate cut? When interest rates are slashed, investors and businesses can borrow at a lower rate. That is why in a low rate environment, businesses look for investment and growth. For instance, If the tensions between the US and China flare-up again, markets sell-off and tariffs are increased, in that case, FED will further cut rate to provide stimulus.
On the other hand, lower rates are a challenge for the banking sector because it becomes exceedingly difficult for banks to lend money at a profitable rate of interest, consequently appending pressure on margins. Therefore, remember banks shares are rarely expected to follow the market trend on rate changes.
Though one can ask that if investors crave for rate cuts, then why are we seeing a negative reaction from the markets? Well, the answer to this question lies in the remarks by the chairman that this rate cut would not be the start of a trend towards lower rates. Secondly, markets were expecting greater cuts due to the dark clouds hanging over the already slowing global economy.
Some commentators are still predicting further rate cuts by FED as there has never been only a single cut before. But the US economic data proves the FED chairman’s view that the economy is still doing strong and this rate cut is just an adjustment.
Let’s see what further decrease or increase in the rates would mean for the markets. Firstly, if the US economy keeps on performing as it has been then we would see the rate keep increasing. That would mean we have seen the medium-term limit on how high the markets can go and they will keep getting rattled by rate increases.
On the other side, if FED decreases the rates again that would start another global trend for central banks around the world decreasing rates to avoid recession and boost growth. So, in that case, we could see markets roaring upward.
Another aspect of the FED rate cut is the currency. Interest rate hike brings in foreign direct investment (FDI), adding to the demand for the value of the currency. Hence, whenever central bank hikes rates you can expect the currency to go up. But since yesterday, we have seen Sterling sink below $1.21 due to gains by the dollar despite the FED rate cut. This is because of dollar gaining strength on comments about no further rate cuts by the FED chairman.
Suleman, 2nd August
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