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The Fed Rate Cut and Your Money

You probably heard the news that the Federal Reserve reduced its federal funds rate from 2 percent to 1.5 percent the morning of October 8. Now let me explain what that means for all of us, during this volatile and scary time…

The federal funds rate is the going rate that banks charge other banks to borrow money. Right now, we are in the midst of a credit crunch. Banks aren’t lending money to anyone, be it other banks or consumers who want a mortgage or car loan.

So the idea with this federal funds cut is to make it even less expensive for banks to loan out money that they can then charge a higher rate on. The goal with this rate cut was for the Federal Reserve to give banks an incentive to lend more money — easing the crunch — because the banks can make more money if they borrow at a lower rate and lend at a higher rate.

That’s the main goal of today’s rate cut that was coordinated with similar rate cuts across the globe: to cajole and entice big banks to get back into the business of lending money to businesses. When that finally starts up again, it will eventually trickle down to helping all of us.

Once banks start lending to each other and to businesses, those banks and businesses will turn around and look for consumers to lend to. No one can tell if this “quiver” that the Fed just used will do the job and start the money flowing again in the credit markets. In fact, many market watchers are concerned that it is still going to take more time, and take more Fed moves to really get the credit markets unfrozen. We will have to wait and see.

Now, in normal times, when the Fed cuts its main lending rate it would mean the rate we all earn on our bank savings and checking accounts would fall too. But these aren’t exactly normal times — and we may see many banks keep their consumer savings rates just where they are, to remain competitive and keep depositors in place.

Impact on Adjustable Rate Mortgages (ARMs)

Another “normal” expectation when we hear the Fed funds rate has dropped is to anticipate ARM rates will be less expensive. Again, these are not normal times.

One of the most widely used benchmark indexes used for determining ARM rates is the Libor index. It is an index based on the going rate for bank lending in England (London Interbank Offered Rate) and the LIBOR index has been skyrocketing. Over the past month it has risen from 3.1 percent to 4 percent.

It is not yet known if today’s coordinated global rate cut will help bring the Libor rate down, so we will all have to wait and see. But a bit of perspective is helpful here: One year ago, the Libor rate was 5.2 percent and back in the fall of 2005 it was 4.5 percent. So if you have a 1-year or 3- year adjustable rate mortgage tied to the Libor, which is resetting soon, you may still see your rate drop. Despite the recent volatility in the Libor market, the current rate is still below what it was one year ago and three years ago.

The Broad Market Outlook

I know that with each mega-drop in the stock market, it is becoming harder and harder to know what to do. Here’s my take:

- There is no quick fix. I personally believe it may take us five or six years to fully recover from this financial crisis. Right now I see our economy and our markets as being in the Intensive Care Unit. Critical condition.

We will probably stay in the ICU well into 2009, before stabilizing a bit and moving out of ICU. But we’re still going to be stuck in the hospital slowly recovering, before moving into a rehab facility to continue mending. It could take four or five years after leaving ICU for the economy to be back in good health.

- Stocks are still best for the long-term. The biggest mistake you can make right now is to stop investing for retirement. If you have at least 10 years until you plan to need your money, then the stock market is still the best place to be investing.

Will the market continue to go down in the short-term? Probably. Will there be lots of meandering ups and downs as the global economy works its way out of this mess? Definitely.

But none of us can anticipate exactly when the turnaround will be. When I say it could take five or six years for things to be fully back on track, that does not mean it can’t happen in three years, or four years, or that during the recovery period some sectors of our economy and the global marketplace won’t get a full bill of health earlier than others. It is impossible to pinpoint any of this.

So the point is, if you have a long-term investment horizon, you want to keep investing. And as we have discussed before, the money you continue to invest in stock funds and ETFs today buys more shares in down markets. And the more shares you own, the more money you will make when the markets rebound.

It is understandable to think that there will never be a market rebound, but that’s the big danger when we are in the midst of a bear market. Losing sight of the long-term. And long-term we can all expect our economy, our markets, and thus our 401(k)s and IRAs to rebound. But you must keep socking away money in your retirement accounts. If you stop contributing now, or move all your money into the money-market/stable value option in your 401(k) it will make it all the harder for your portfolio to recover when the markets rebound. It may not feel like it, but today is when you have the chance to build retirement security. By sticking with your long-term investment strategy during a bear market you are putting yourself in the perfect position to profit in a bull market.

One strategy you might consider is to stick with stocks, but switch intostock fundsor exchange-traded funds (ETFs) that pay you a nice dividend to just sit and wait till we are out of rehab. One of my favorites is currently the ETF with the symbol DVY . It selects the highest-yielding stocks in the Dow Jones average and you buy a basket of them all — it will pay you a nice dividend yield of about 5 percent, and years from now, when the markets do recover, you will see your money grow as well.

Please note: Just because you are getting a nice yield does not mean the share prices of the DVY will not continue to go down. If the Dow Jones Industrials Average goes down, so will the DVYs. The difference is that at least you will be getting 5 percent on your money while it does decline.

So if this is a strategy that may work for you, please don’t put everything you have into the DVY; just buy a little amount every month, for again I state, that these share prices will also go down if the markets continue to go down.

- Stocks are never right for the short-term. As I have always said, if you need to use your money in the next year, or two or three, you cannot afford to be invested in the market. This is true in bear markets as well as bull markets. When you do not have time on your side, investing in stocks is simply too risky.

If you have a bill coming due in the next year or few years and you are thinking you will just leave your money in the stock market and hope for a big rally between now and then, I am telling you to wake up. Investing is not about hoping, it is about dealing with reality. And the reality is your money didn’t belong in stocks in the first place. So the right thing to do is to bite the bullet and sell any stock investments that is money you need within the next few years.

That money belongs in FDIC-insured bank accounts, federally insured Credit Union accounts, or money market mutual funds that invest in U.S. Treasuries.

Sell your stocks at a loss and you will get some relief come tax time. Capital losses can be used to offset capital gains on your federal tax return. Or, if you don’t have any capital gains, your losses can be used to offset income. The bottom line is that when you take a loss on a stock sale, Uncle Sam gives you a tax break one way or the other. So there you go: a silver lining amid this market mayhem.

Now you know.

-Suze

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