Understanding basic economics can lead to huge profits in the markets.
You see, the Federal Reserve announced this week that they would lower interest rates. And not knowing how this rate cut will move the market could lead to some serious financial damage…
But understanding what it means for you and your trading could lead to huge profits.
This is how you can profit off of this week’s Fed announcement…
Four Simple Ways to Turn the Interest Rate Cut into Cash
Now, “interest rates” is a term that’s been floating around the market for a while now. They affect the economy and move the markets, and in turn, can end up putting a good chunk of change in your pocket.
To understand exactly why and how this happens, it’s important to know what the Fed is and does. The Fed is the United States central banking system, established in 1913 to alleviate financial crisis. Its primary monetary objectives are to maximize employment, stabilize prices, and moderate long-term interest rates.
One way the Fed meets these objectives is to adjust what’s called the “Federal Funds Rate.” Also called the “Overnight Rate,” this is the rate at which banks lend money deposited by the Federal Reserve to each other. This rate is then passed down through the lending system to the consumer – that’s you. The interest rates you see on your credit cards and loans all reflect the current funds rate.
Think of it this way – the Federal Funds Rate is the cost of money.
When the cost of money is high, it slows the economy and curbs inflation. When the cost of money is low, it stimulates the economy and curbs deflation. Interest rates are basically the gas pedal to the US economy, and the Fed has its foot on it.
Now, the pundits on the mainstream news networks are focusing on the negative aspects of lowering rates, like people not earning as much in savings. This is generally true, but there are a lot of good things that this rate cut can do for your money too, and that’s the most important aspect to focus on.
The Fed’s decision to drop interest rates this week also lowered the rates on your credit card and mortgage. The cost of money is lower, so you can buy more things. Businesses are making more money, and the economy is stimulated.
But those aren’t the only ways you’ll see the rate cut in your own day-to-day life. All of this affects your trading game too. And more importantly, the interest rate chaos can actually make you money.
To understand how, let’s look at four market areas: stocks, bonds, currencies, and commodities.
- The Stock Market
This one’s simple. If the cost of money is low, consumer spending and demand increases. Companies make more money. Furthermore, businesses can borrow more money at cheaper rates to stimulate growth. All of this spells more revenues and more profits for companies.
This reliable correlation is invaluable information. For example, when the Fed lowers rates, we can reliably expect the stock markets to rise over time. That means that now is the time to be bullish. You can even trade the major markets with exchange traded funds (ETFs). Here are some of the most popular and lucrative ones:
|Dow Jones 30
If the economy and stock market are stimulated, then buying and holding any of these will bring in profits. If you wanted to buy an option on any of these ETFs, then you should look far ahead – consider buying a long-term call to profit.
- The Bond Market
Given that bonds are essentially loans, interest rates have a direct correlation to bond prices. We’ve talked about the yield curve before. The yield (return) of a bond is determined by its coupon rate, which in turn is impacted by the fed funds rate.
Therefore, when interest rates drop, the value of the bonds in circulation (that now have a higher coupon rate) become more valuable. This leads to a rise in the bond market.
Of course, it works the other way too. A rise in interest rates makes the value of bonds in circulation drop, creating a drop in the bond market.
The most popular bond ETFs are the treasury bonds, as shown below:
|iShares Barclays 1-3 Year Treasury
|iShares Barclays 3-7 Year Treasury
|iShares Barclays 7-10 Year Treasury
|iShares Barclays 3-7 Year Treasury
|iShares Barclays 20+ Year Treasury
You can expect any of these to rise on lower interest rates. To profit, you can buy the ETF or calls on the ETF. In this case, either will make money.
- Currency Market
Higher interest rates generally increase the value of a country’s currency, and vice versa. When interest rates are high, they attract foreign investments and increase the demand, and therefore value, of a country’s currency.
Now, just like with bonds, the opposite is also true. And of course, other factors like political/economic stability and demand for a country’s goods impact the value of a country’s currency as well.
So, the Fed’s rate cut will lead to downward pressure on the U.S. dollar.
Here are some ETFs to consider if you want to bank profits on currencies:
|Invesco DB US Dollar Index Bullish
|WisdomTree Bloomberg US Dollar Bullish
|Invesco DB US Dollar Index Bearish
If you buy the USDN ETF, you will profit if the dollar weakens. You could also buy puts on the UUP. With lower rates, this ETF may very well drop, increasing the value of the puts.
- Commodities Market
Interest rates have a direct impact on the cost of holding hard commodities like oil, gold, and soy beans. Higher inventory costs reduce demand, which in turn tends to drop commodity prices. Lower interest rates therefore reduce inventory costs while increasing demand and price.
There are many popular commodity ETFs. Here are a few of them:
|United States Oil Fund
|SPDR Gold Trust
|iShares Silver Trust
|United States Natural Gas Fund
|Unites States Gasoline Fund
Expect these ETFs to rise on the Fed’s rate cut. Go long the ETF or buy calls – both will work.
As you can see, interest rates have a dramatic impact on all four corners of the market. Understanding the basic relationships between them gives you a huge edge – and could result in a life-changing amount of money.
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