The Fed's latest rate cut

The US Federal Reserve has cut interest rates again, from 4.5% to 4.25%. Not unexpected, but obviously the market wanted more.

Ah yes, but which market wanted more?

The response to the cut by the sharemarket was swift. The good 'ol Wilshire 5000 dropped 2.53%, wiping out about US$387 billion in the process, which is a pretty big drop for the day.

The response by the foreign exchange market was similar - the US Dollar dropped like a rock but then bounced up like a very bouncy rock and finished the day higher than what it was.

So what do we learn from this?

Well, we learn that two markets wanted two different things. The sharemarket - essentially American investors - often see rate cuts as being good things. The last time the rate was cut, to 4.5%, the market responded in its usual euphoric and utopian way, indicating that such a rate cut was a sign that heaven on earth was possible. So why was their reaction to this rate cut, from 4.5% to 4.25%, accompanied by the market's usual pessimistic, dystopian attitude that indicates that the world will end?

Well it seems as though the sharemarket was factoring in a greater cut. And when they didn't get it, they went gaga and people were yelling "SELL!!! SELL!!" into their phones while simultaneously ripping out hair from their already balding scalps.

The Forex market - basically those people who buy and sell currencies around the world and who represent the international market - seemed, after getting a fright, to be reasonably pleased with the outcome. In other words, the Forex market had expected this rate cut and had already factored it in - which is why the US Dollar went nowhere - while the sharemarket expected more and was sad that it was disappointed.

But, had the Fed reduced rates by 50 basis points - from 4.5% to 4.0% - what would have happened? Well, the sharemarket would have been quite happy and share prices would have gone up - not as much as 2.53% but probably between a 1% and 2% gain. The Forex market would have gone gaga and people all over the world would be yelling "SELL!! SELL!!" into their phones while simultaneously ripping out hair from their already balding scalps.

But let's suppose the Fed did something different. Rather than dropping rates by 50 basis points, what would've happened had they reduced them by 75 basis points - from 4.5% to 3.75%?

Well, of course, the Forex traders would be yelling sell sell sell sell and ripping out twice as much hair from their heads and maybe even creating negative amounts of body hair on their person.

But would the sharemarket react happily? No. They probably would've said "OH NO! THE PROBLEM MUST BE WORSE THAN WE THOUGHT! ARGGH!!!", accompanied by loud selling on the phone and negative levels of body hair.

But now let's suppose that the Fed increased rates, from 4.5% back to 4.75%. Obviously the Forex traders would be floating on cloud nine, looking forward to utopia and heaven on earth, while the Sharemarket would've been saying "OH NO! INFLATION MUST BE A HUGE PROBLEM! ARGGGHH!!", accompanied by overuse of the sell word and a bunch of Patrick Stewart lookalikes.

Lesson - lots of people with lots of money can go crazy.

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