Analysis: How low can Fed go on interest rates?
By JEANNINE AVERSA FROM BUSINESSWEEK
Just how far will the Federal Reserve go in lowering interest rates to save the country from a long and painful recession?
Ratcheting its key rate from the current 1 percent all the way down to zero can’t be ruled out. But there are risks in taking such an unprecedented step: namely, that it wouldn’t work in turning around the economy and breaking through a stubborn credit clog.
Eventually, a zero percent rate — virtually “free” loans for banks — could trigger a speculative investment frenzy that could feed a bubble that pops, wreaking havoc on the economy. Former Fed Chairman Alan Greenspan — now partly blamed for the current problems — has called today’s crisis a “once-in-a-century credit tsunami.”
Emphatic as it was, the bold rate reduction the Fed ordered Wednesday and the possibility of even lower rates ahead are no panacea. Even lower rates won’t necessarily entice skittish Americans to spend and squeezed banks to lend more freely — forces at the heart of the economic woes.
With any luck, though, the Fed’s action will cushion the blow to the country, which is on the brink of — or already in — its first recession since 2001.
The Fed slashed its key rate by half a percentage point to 1 percent, a rate not seen since 2003 and part of 2004. The rate hasn’t been lower since 1958.
In a gloomier assessment of the economy, Fed policymakers said “the pace of economic activity appears to have slowed markedly” as consumers and businesses cut back on spending, and economic slowdowns in other countries sap demand for U.S. exports, which have helped keep the economy afloat.
Moreover, the “intensification of financial market turmoil” is likely to weigh on consumers and businesses, further reducing their ability to borrow money, the Fed said.
Underscoring the Fed’s sense of urgency is this fact: It took just 13 months for Fed Chairman Ben Bernanke, a student of the Great Depression, to ratchet down rates to the 1 percent mark. It took his predecessor, Greenspan, 2 1/2 years.
Many economists predict Fed policymakers will drop the rate again to half a percentage point, which would mark an all-time low, on or before Dec. 16 — its last scheduled meeting of the year. The Fed left the door wide open to more rate cuts, pledging to “act as needed” to revive the economy.
“We are in a crisis situation and everything is on the table,” said Richard Yamarone, an economist at Argus Research. “If conditions deteriorate considerably, the Fed could go down to zero. It is absolutely a possibility, but I don’t believe it is likely.”
Yet even if the Fed were to lower its key rate to zero, that might not reverse the bunker mentality of consumers and lead them to ramp up spending.
More than in recent recessions, consumers have retrenched as vanishing jobs, shrinking paychecks and nest eggs, and sinking home values have made them feel less wealthy and less inclined to spend. Consumer spending — the single biggest chunk of overall economic activity — probably fell in the July-to-September quarter. That would mark the first quarterly drop since late 1991, when the country was emerging from a recession.
And just because borrowing costs are cheaper doesn’t mean banks will feel more inclined to beef up lending to people and businesses.
“The problem is not the interest rate,” said Sean Snaith, an economics professor at the University of Central Florida. “It is that no one is willing to loan, regardless of what the rate is. Lower rates will not make the problem go away. The credit crunch will take time to resolve. This is another action to just chip away at the gridlock in this economy, but we shouldn’t expect a miraculous turn of events from this.”
The Fed’s move Wednesday meant the prime lending rate used to peg rates on home equity loans, certain credit cards and other consumer loans dropped to 4 percent. Even if the Fed were to cut its main rate to zero, the prime rate would fall to 3 percent but no lower.
The Fed’s previous rate reductions, in fact, were blunted by the credit crunch. The Fed slashed rates by a whopping 3.25 percentage points, from 5.25 percent to 2 percent, between September 2007 and April 2008, one of the most aggressive campaigns in decades. On Oct. 8, the Fed lowered rates again to 1.5 percent in a coordinated action with other central banks around the world.
The Fed probably would want to stop short of zero, so it saves precious ammunition — meaning additional rate cuts — should the economy take a turn for the worse later on, some economists said.
Others believe the Fed would want to avoid the fate of Japan, which failed to revive its economy even after its central bank slashed rates to zero in 1999 and kept them there for six years before bumping them up again. Japan became mired in a decade of lost growth in the 1990s after real-estate prices collapsed. That caused a severe bout of deflation, which is a destabilizing drop in prices.
“Cutting rates to zero is a fairly desperate measure, and a lot of stigma is attached to it,” Snaith said. “It would bring on comparisons to Japan.”
There’s also the worry that dropping rates to all-time lows would feed the type of speculative boom and painful bust that the country is now suffering through. Greenspan lowered rates to 1 percent in summer 2003 as he sought to aid the economy’s slow recovery from the 2001 recession and fend off a remote — but dangerous — risk of deflation. He kept rates at that historically low level for a year.
Critics contend that those low rate fed the housing bubble and lax lending standards that eventually burst and imperiled the economy. The meltdown drove up foreclosures and forced financial companies to rack up huge losses on soured mortgage investments, laying low storied Wall Street firms and causing banks to fail.
Instead of dropping rates to zero, the Fed probably will turn to other weapons to battle the crisis.
The Fed has already created first-of-its-kind programs, such as getting cash directly to companies by buying up mounds of “commercial paper,” the short-term debt firms use to pay everyday expenses such as payroll and supplies. That program, which started Monday, is helping to relieve credit stresses, economists said. The Fed also is providing loans to banks, has moved to provide a financial backstop to the mutual fund industry and has injected billions of dollars in financial markets here and abroad.
The Fed could opt to expand programs by enlarging loans it’s now making, providing loans to other types of companies, or buying more and different types of debt. The Fed’s balance sheet has doubled to $1.8 trillion in recent months, reflecting those other activities to get credit flowing again.
Because the Fed has wide latitude in these areas, many economists believe Fed policymakers are more likely to continue this route than to lower its key rate to zero.
No matter the relief tactics, though, the economy is due for more pain. The unemployment rate, now 6.1 percent, could hit 8 percent or higher by next year. Home prices are likely to keep sinking for some time, and nest eggs will continue to be battered.
“We’ve been in pain, and it will get more much severe over the next six months,” predicted Mark Zandi, chief economist at Moody’s Economy.com. “The economic damage of the financial panic has already been done, and the Fed is trying to limit the damage as best it can.”
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Top options play II - Protective put
Psychology
You’re bullish, but nervous.
The Setup
• You own the stock
• Buy a put, Strike Price A
• Generally, the stock price will be above Strike A
THE STRATEGY
Purchasing a protective put gives you the right to sell stock you already own at Strike Price A.
That can help protect the value of stocks in your portfolio in the event of a downturn. It’ll also help you cut back on your antacid intake in times of market uncertainty.
Protective puts are often used as an alternative to stop orders. The problem with stop orders is they sometimes work when you don’t want them to work, and when you really need them they don’t work at all. For example, if a stock’s price is fluctuating but not really tanking, a stop order might get you out prematurely. If that happens, you probably won’t be too happy if the stock bounces back. Or, if a major news event happens overnight and the stock gaps down significantly on the open, you might not get out at your stop price. Instead, you’ll get out at the next available market price, which
could be much lower.
If you buy a protective put, you have complete control over when you exercise your option, and the price you’re going to receive for your stock is predetermined. However, these benefits do come at a cost. It would be nice if the stock goes up at least enough to cover the premium paid for the put.
If you buy stock and a protective put at the same time, this is commonly referred to as a “married put.” For added enjoyment, feel free to play a wedding march and throw rice while making this trade.
TIPS
Many investors will buy a protective put when they’ve seen a nice run-up on the stock price, and they
want to protect their unrealized profits against a downturn. It’s sometimes easier to part with the money to pay for the put when you’ve already seen decent gains on the stock.
Top options play I-Covered calls
Psychology
You’re neutral to bullish, and you’re willing to sell stock if it reaches a specific price.
The Setup
• You own the stock
• Sell a call, Strike Price A
• Generally, the stock price will be below Strike A
THE STRATEGY
Selling the call obligates you to sell stock you already own at Strike Price A if the option is assigned.
Some investors will run this play after they’ve already seen nice gains on the stock. Often, they will sell out-of-the-money calls, so if the stock price goes up, they’re willing to part with the stock and take the profit. Covered calls can also be used to achieve income on the stock above and beyond any dividends. The goal in that case is for the options to expire worthless. If you buy the stock and sell the calls all at the same time, it’s called a ”Buy / Write.” Some investors use a Buy / Write as a way to lower the cost basis of a stock they’ve just purchased.
TIPS
1. As a general rule of thumb, you may wish to consider running this play approximately 30-45 days
from expiration to take advantage of accelerating time decay as expiration approaches. Of course, this
depends on the underlying stock and market conditions such as implied volatility.
2. You may wish to consider selling the call with a premium that represents at least 2% of the current stock price (premium ÷ stock price). But ultimately, it’s up to you what premium will make running this play worth your while.
3. Beware of receiving too much time premium. If the premium seems abnormally high, there’s usually a
reason for it. Check for news in the marketplace that may affect the price of the stock. Remember, if
something seems too good to be true, it usually is.
Stocks: Getting Closer to a Bottom?
This report was issued by Standard & Poor’s Equity Research Services on Oct. 24
S&P chief technical analyst Mark Arbeter thinks a bottom will be signaled once consistent buying demand from institutions starts to emerge
Stock market futures were limit down during pre-market trading this morning, as markets around the world crashed overnight. The last time we saw this type of premarket activity was a brief time on January 22, and, of course, on 9/11 and during the crash in 1987. These circuit breakers were instituted after the ’87 crash and were instituted to prevent another crash and let cooler heads prevail. Whether they work this time is anybody’s guess. Maybe this type of price action is what we finally need to clear the decks, wash things out (even more), and help create some type of tradable low. But we just don’t know.
Global markets got crushed overnight with the Nikkei plunging almost 10%, the Hang Seng over 8%, the FTSE almost 8%, and the DAX almost 7%.
The reasons for the latest weakness are some very weak corporate earnings reports overseas and worries about the meltdown in the global economy. This has led to continued selling by institutions as they are forced to raise cash. We look for some major action by the government like further cuts in interest rates, more stimulus packages, and if things really get out of hand in the equity markets, a trading halt for a day or two or possibly longer.
Also, don’t be surprised if the government intervenes in stock futures, which they have done in the past to support cascading prices.
Technically, the S&P 500 undercut the October 10 closing low of 899 earlier this week and is rapidly closing in on the 10/10 intraday low of 840. Below this, the next support is the October 9, 2002 bear market low of 777. Quite frankly, we think we are in a panic mode, and when this occurs, technical and fundamentals become less meaningful. While we will not know at what P/E the market may bottom, or at what technical support it may hold, we think a bottom will be signaled once consistent demand from institutions starts to emerge. As we have been saying, we also think there is a decent chance of a very large move to the upside once a bottom has been reached, given that the market has gone virtually straight down, and that there is little overhead resistance on the way back up.
If we are unable to hold the prior bear market lows at 777 on the S&P 500, then things get even cloudier (if possible). There are not any major layers of chart support to speak of beneath the 777 level, at least for a long way down. There is, however, a very long-term trendline off the 1932 lows that comes in between 600 and 700. First off, because this line is so long, it does not match up perfectly with some of the major lows over history, so where it is placed becomes somewhat subjective.
Secondly, determining an exact support level from this line is very difficult, because +we do not know if the “500” will fall directly to this support line, or if we get there many months from now. Therefore, we have given a wide range for this potential support from 600 to 700.
We have said in the past that once an index retraces more than 61.8% of the prior bull market, it is then very susceptible to a full retracement. Sam Stovall, S&P’s Chief Investment Strategist, took this analysis one step further in the hopes of pinpointing a potential bear market bottom. He looked at all the instances where the S&P 500 retraced over 61.8% of the prior bull market and then measured how much more damage had occurred. During the 1929 – 1932 bear market, the “500” retraced 108% of the previous bull market. The 1938 to 1942 bear saw a 119% giveback, the 1968 to 1970 decline retraced 111%, while the ‘73/’74 collapse resulted in a retracement of 114% of the prior bull market. The one instance when the “500” gave back more than 61.8% of its previous bull market and did not retrace a full 100% was the bear market of 1937/1938 when the index gave up 96%.
Averaging all these occurrences gives us a retracement of 110% and that would equate to a move to 700.
Volatility indices spiked this morning with the VIX (options on the S&P 500) surging to almost 90%, the VXO (options on the S&P 100) to 86% and the VXN (options on the Nasdaq) to almost 87%. These are extreme readings, but these are extreme times. Put/call ratios on an intraday basis are fairly elevated today something from a sentiment standpoint that has been missing during the recent selling. At this point, we would like to see a hard bottom with prices closing near their lows today, a sharply lower open Monday, followed by a large upside reversal. However, what we want and what usually happens are two different things.
Crude oil as well as most other commodities have plunged due to the quick downturn in global economies, unwinding of speculative bets, forced liquidation, and a huge rally in the U.S. Dollar Index. While this hurts if you are invested in commodity stocks, it certainly reduces input costs for corporations and acts like a huge tax cut for consumers. The catch 22 part of this is that commodity prices are falling in part because of a weakening global economy, but it may be prop for corporations and individuals alike, and soften the impact of previously high prices. Everyone thought $100+/barrel oil would cause a global recession. However, perhaps sub-$70/barrel crude oil will act as a buffer for the global economy.
Technically, crude has dropped into a wide area of chart support between $55 and $70/barrel. Long-term trendline support, drawn off the 1998 bottom, comes in around the mid-$60’s. Prices, which were almost 50% above the 65-week exponential average in June, are now almost 33% below the 65-week average.
Clearly, the oil market has gone from an extreme overbought to extreme oversold position in just five months. The markets are sometimes like a rubber band, and the oil market as well as equity markets seem stretched to the limit right now
–Businessweek
Options Basic II - Calls and Puts
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.
Participants in the Options Market
There are four types of participants in options markets depending on the position they take:
1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts
People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.
Here is the important distinction between buyers and sellers:
-Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose.
-Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.
Don’t worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.
The Lingo
To trade options, you'll have to know the terminology associated with the options market. For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value. The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility. Because of all these factors, determining the premium of an option is complicated and beyond the scope of this tutorial
The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock price must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.
An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).
Options Basics I - Concept of an option
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.
The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you’d love to purchase. Unfortunately, you won’t have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.
Now, consider two theoretical situations that might arise:
1. It’s discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).
2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.