Things Aren't Always What They Seem

Last month, Ben Bernanke cut interest rates by 50 basis points. Next week, he may cut them again...

What does this mean for our investments? The answer is not as obvious as everyone thinks...

First, when the Fed cuts rates, people assume it'll be good for stocks. After all, lower interest rates reduce borrowing costs for America's companies. And lower borrowing costs mean higher profits.

Second, gold should go up. Gold pays no interest. It competes against other assets that do pay interest. When the Fed cuts interest rates, those assets pay less interest. So gold's "relative yield" looks better.

Third, the dollar's exchange rate should go down. When your neighbor offers a higher interest rate than you do, more money will flow to your neighbor's currency. So when the Fed cuts interest rates, the dollar becomes less attractive versus everyone else's currencies. And it falls...

Simple isn't it? But wait... not so fast... I've got some information for you... and I think you'll find it very surprising...

Two out of three of these "conventional" beliefs are wrong. Let me explain...

Jason Goepfert is a "sentiment" trader. He studies the crowd's sentiment and makes trades based on his findings. For example, if the crowd is very optimistic, Jason will go short. If it's pessimistic, Jason will buy. It's simple contrarianism. Jason publishes his findings at www.sentimentrader.com. It is one of the few sources Steve and I cannot live without.

Last month, Jason published new research on his site. Since 1971, the Fed has started eight rate-cutting campaigns. Jason defines a rate-cutting campaign as a reduction in the Fed's discount rate after a period of raising rate... or a reduction in the Fed's discount rate after going more than a year without changing rates.

Jason looked at each of these rate-cutting campaigns and studied the reactions of gold, the dollar, commodities, and stocks in the year that followed them. Here's what he found:

Average performance of gold, U.S. dollar, stocks, and commodities after the Fed starts a rate cutting campaign...

Conventional wisdom says the dollar falls during Fed rate cutting campaigns. I saw this headline on Bloomberg this morning: "Dollar falls to record low versus euro on speculation Fed will cut rates."

The reality is, except for 1984, the dollar rose every time, while gold fell during six out of eight rate-cutting campaigns. "From the precedents we have," writes Jason, "four themes are clear. Fed easings have been good for stocks, good for the U.S. dollar, bad for gold and bad for commodities."

Yes, all of the headlines say lower interest rates mean a lower dollar... but as history shows, things aren't always what they seem.

Good investing,

Tom