Bernanke’s First Show After Taking Office

The financial markets were jubilant on Tuesday after the Federal Reserve slashed interest rates by a greater-than-expected 50 basis points. (Note that one basis point is 1/100th of a percent.) It was a glorious day that has sent global stock markets, gold and the Canadian dollar through the roof. The next logical question is whether this downward move in rates is going to prevent recession in the U.S., soften the blow in the long-run, or merely delay the inevitable.

With respect to the first scenario, just the fact that the Fed has cut interest rates so dramatically, after increasing them for the past four years, indicates that the recession in the U.S. is a more real threat than the Fed was ever willing to admit. Historically speaking, it is not likely that one change in monetary policy, however powerful it may seem at face value, will or can stop the powerful wheels that have been set in motion by the depressed housing market and debacle in the credit market.

As far as softening the blow in the long run is concerned, obviously one rate cut of 50 basis points is not going to be sufficient to fix everything that is wrong with the U.S. economy. Experts estimate that there are about two million adjustable-rate home loans given to people with weak credit and low incomes that are in very real danger of defaulting.

First, initial low rates have expired and homeowners will start receiving bills at new rates of 6.75%. Granted, rates are lower after the Fed cut its funds’ rate on Tuesday, but they are still too high for most homeowners, many of who cannot afford exorbitant prepayment penalties or even to sell their homes.

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Second, consumers are also not likely to rush the malls, mostly because the U.S. job market is also sagging. In August, the economy shed 4,000 jobs, which represents the first decline in the last four years. The unemployment rate is currently at 4.6%, but analysts expect it to increase to five percent by the year end. With the weakened job market, workers are also likely to experience slower wage increase rates. And with slower wage growth, consumers are more likely to have less extra dollars to spend in malls.

The worst case scenario for the U.S. economy is, of course, succumbing to the recession. Even the former Fed chairman, Alan Greenspan, admitted recently that while the odds of recession are still not at 50/50, they have certainly moved up higher than one- third, too. By cutting the interest rates so dramatically, the Fed’s new chairman Bernanke has finally decided to moderate the economy through monetary policy. The bad news is, however, that in doing so, he has also admitted that recessionary fears may be justified.

But, what does it all mean for Canadian investors? In the short-run, it appears there will be plenty of opportunities. Stock markets, our dollar, and gold are soaring. Canada’s strength is in resource stocks and some commodities, particularly gold and energy (stocks), are currently performing extremely well.

With the Canadian dollar soaring against the U.S. dollar, currency hedging can also be a potential source of profitable opportunities. One such strategy would be a one-time transaction, whereby an investor purchases forwards or call options in order to both protect himself from or to profit from the rising Canadian dollar. On the other side of the spectrum are extremely sophisticated program trades involving various combination of forwards, options or swaps. In any event, in the case of currency hedging, you would be best advised to talk to your broker.

Canadians could also profit from investing in Canadian manufacturers that profit from importing cheap productivity- enhancing products. Considering the high probability of the Canadian dollar’s parity with the greenback, Canadian companies can now afford to substitute labor with capital spending to increase productivity. Another positive side effect of this substitution is the potential to offset losses in export competitiveness due to the stronger domestic currency.

When getting down to the nitty-gritty and trying to find which industries could benefit from a higher Canadian dollar (from the capital investment point of view), we can identify the manufacturing sector, which is extremely capital-intensive, as well as base metals mining, oil and gas, chemicals and paper, all of which positively head the list. Following very closely on that list are education services, truck transportation, broadcasting and telecommunications, as well as agriculture.