Thursday, November 6, 2008

When Stimulus Ceases to be Stimulating

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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Apparently Pavlov was right - and a better economist than anyone ever imagined. More than 100 years ago he noted that a stimulus has its greatest effect in the beginning and loses it impact if continually applied. Contemporary central bankers have apparently failed to appreciate the significance of this finding and its application to their field.

Early this morning New York time, the Bank of England cut interest rates 1.5%. While this may not be the biggest rate cut ever in nominal terms, it is enormous by any measure. The old rate was 4.75 and the new one is 3.25. Before the credit crisis began last year, a rate cut of this magnitude would have been enough to rally the market 10%, 15% or maybe even 20% in as little as a few days. However, as the credit crisis has proceeded, central banks rate cuts have lost their efficacy. The rallies that have resulted have become smaller and briefer. Today the FTSE 100 closed down 5.7%. Instead of the expected big rally, the London market crashed.

The Bank of England's grand rate cut gesture was a follow-up to the U.S. Fed's 50 basis point pre-election rate cut last week. While the Fed's cut helped prop up the American stock market into the voting, it could have done even more and there were rumors that it was considering 75 or even a 100 point cut (the remaining 25 or 50 basis point cut will probably be done at the next meeting). The ECB and the Swiss central bank decided to follow this more conservative approach today when they both cut 50 basis points also. Euro zone rates are now at 3.25%, above Britain's new 3.00% and well above the 1.00% in U.S. Counterintuitively, the trade weighted dollar rallied. This pattern has been seen since late July when funds have been flowing from high interest rate currencies to low interest rate currencies - something which seems to defy all logic.

Bourses on the continent suffered even more today than the British market, since they only had a big rate cut, instead of a truly huge rate cut to support stock prices. The German DAX was down 6.8% and the CAC-40 dropped 6.4%. The U.S. markets started selling as soon as they opened and hit a temporary bottom around 1:30, when the Dow was down more than 400 points and Nasdaq down over 70. Oil prices was hit even worse than stocks, with light sweet crude falling to $60.16 at one point. Don't be surprised if oil falls even further to 50 or even 40 in the future, although this may take awhile. In the shorter term, current levels are likely to be broken for stocks.

NEXT: Employment Losses Revealed After the Election

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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