Question

Suppose the Federal Open Market Committee decides decrease the target federal funds rate from 2-2.25% to 1.5%, analyze:

(1) How the financial markets will be affected, including money market, bond market, stock market, mortgage market, foreign exchange market.

(2) How an American investor who currently holds U.S. bonds, U.S. stocks, eurodenominated stocks should adjust his/her portfolio.

Answer 1

If federal fund rates reduces, it means banks can borrow money from Central bank at cheaper rates. This inturn implies that companies and people can borrow money from banks at cheaper rates. This will increase spending in the economy. It means more production for companies. It means healthy financials for companies. So stock prices will go up. Similarly other markets will get affected.

Also, if lower fed rate means, interest earned on deposits from banks also less. So people want to invest in market. Hence stock market will go up. Whereas bond market might get negatively effected because it gives low interest rate.

Someone who holds portfolio should increase investments in stocks rather than fixed income securities which gives less return.