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What the Fed's big rate cut means to you

If you’ve been investing for a while, you’ve lived through the '87 crash and the tech-stock collapse , but that doesn’t make this year’s plunge easy to stomach. So, what’s it mean to ?
/ Source: contributor

Wow! Tuesday was like a bungee jump for investors, with stocks plunging at the market opening, recovering and then dipping again before ending the session with modest losses.

If you’ve been investing for 10 to 20 years, you’ve lived through rough spots like the '87 crash and the tech-stock collapse early in this decade, but that doesn’t make this year’s market plunge easy to stomach. With fear of a recession mounting, the Dow Jones industrial average and other key U.S. and foreign-stock indicators have been heading down — way down.

In a highly unusual move, the Federal Reserve on Tuesday slashed the fed funds rate to 3.5 percent, from 4.25 percent, hoping to calm the markets and to stimulate the slowing economy and avert recession. That the Fed did so a week before its scheduled meeting underscores how perilous conditions have become.

So, what does it mean to you?

First, the good news: If you need to borrow money, it might get cheaper. Rates on 30-year, fixed-rate mortgages already have fallen to about 5.4 percent from 6.3 percent six months ago. These rates take their cue from 10-year U.S. Treasury bonds, whose yields have fallen to 3.4 percent from 4 percent at the start of the year, so maybe the 30-year mortgage will fall even further.

If you are thinking of buying a new home or refinancing a mortgage, consider waiting two or three weeks to see what mortgage rates do. There’s not much risk they’ll go up significantly, and there’s some chance they’ll drift down. Some analysts think the Fed may cut rates again Jan. 30 after next week's two-day meeting.

Adjustable-rate relief?
Homeowners with adjustable-rate mortgages also may benefit from the Fed rate cut, which could lower the indexes used to reset adjustable loans. The one-year Treasury bill, for example, now yields about 3 percent, down from 3.2 percent a month ago and 5 percent a year ago.

In other words, if your loan resets every 12 months and used the one-year Treasury for a reset today, the interest rate could drop by two full percentage points, perhaps saving you hundreds of dollars a month.

Still, you might consider using this opportunity to refinance to a 30-year, fixed-rate loan. You could lock in that unusually good, below-6 percent rate and avoid rate hikes you might face in the future with an adjustable loan.

The general decline in interest rates could influence rates on car loans, credit cards and home-equity loans, but so many factors affect those rates that it’s too soon to know for sure. With interest rates in flux, keep an eye out for good deals.

Of course, lower rates are not so great for people trying to earn interest. But don’t despair — some institutions are still offering healthy rates of 4 to 5 percent on savings accounts and certificates of deposit. That’s because they’re hungry for cash to make loans.

Shop for CDs at and take a look at the 4 percent savings-account rate at ING Direct and the 5 percent savings at E*Trade. Remember that savings-account rates can change at any time, while CD rates are locked in.

If you are a fixed-income investor looking around for better yields, beware the siren song of junk bonds. Many are showing yields of 10 percent or more, but that’s because high-yield bond prices have fallen as investors worry about default, which is when a bond fails to make the interest and principal payments promised. Defaults tend to rise in recessions. In fact, when falling junk bond prices are taken into account, their owners have lost money this year despite the high yields.

What about good-quality long-term bonds like 10-year Treasuries or high-rated corporates? Investors probably should not do anything dramatic with these, either. Many mutual funds owning long-term bonds have beaten stock funds over the past year because falling yields have driven up the prices of older bonds that are more generous.

But now long-term yields are so low it’s hard to imagine bond investors will enjoy similar returns this year, and you certainly won’t make much on interest earnings. Today, the main reason to invest in long-term bonds is to diversify, or spread out risk. If you allocate a certain percentage of your portfolio to bonds, stick to your target, and leave the bond-price speculation to the pros.

Stock-market investors can be excused for scratching their heads — or hiding under the covers. The recent declines are stomach-churning.

But what’s next? The glib answer, of course, is that no one knows for sure. Generally, lower interest rates are good for stocks, because if investors can’t make much with savings accounts, CDs, money markets and other “cash” holdings, they’re willing to take risks with stocks. Higher demand for stocks should push stock prices up.

Except that many other factors can interfere. The slowing economy, for example, means businesses and consumers are likely to spend less, reducing corporate earnings, which are key to stock gains. Currently, there’s also a great deal of worry that we have yet to suffer all the fallout from the credit crunch that began with the subprime mortgage debacle.

Searching for value
Historically, small-company and value stocks tend to do better during recessions than big-company and growth stocks. But both these categories have done well recently, so it may be too much to expect further gains. Also, the value-stock indexes are crammed with financial-company issues, and the financials are still at risk because of the credit crunch and collapse of mortgage-based securities.

Similarly, foreign stocks have tended to beat U.S. stocks during recessions, but that just means they lost less. And foreign stocks, like small and value stocks, have done well in recent years, so it may be a too late to pile in.

Does that mean stock investors should run for the sidelines?

Not all all. The lesson from history is that stocks tend to beat cash and bonds over long periods, and there’s no real reason to think that won’t be so in the future. I’ve talked to lots of experts in the past week and their advice to shareholders is almost unanimous: Hunker down and stay the course.

You should not have money in stocks that you will need over the next five years, and the odds are that stocks will be higher in five years than they are now, perhaps substantially higher.

While history shows that recessions tend to drive stocks down and recoveries to lift them up, it also shows it’s impossible to predict when a recession will begin or end. Even if you knew that, you could not predict the stock moves. In the past nine recessions the stock decline has begun anywhere from one to 13 months before the start of the recession, and the stock rebound began anywhere from eight months before the end of the recession to 12 months after.

So the best move now is to stick with your long-term plan. If it calls for 60 percent stocks, 30 percent bonds and 10 percent cash, make only the adjustments necessary to keep to those targets. And don’t do it every day, or you’ll rack up a lot of unnecessary trading costs. Wait until you are 5 to 10 percentage points off target, and, if you can, make adjustments in your tax-sheltered accounts like IRAs and 401(k)s, so your sales won’t trigger tax bills.

Finally, keep putting money in — through automatic weekly or monthly contributions to your retirement account, for instance, or with a similar automatic program allowing your brokerage or fund company to draw on your bank account.

After all, for a long-term investor these down times are good: You can buy stocks for less than they cost a few months ago.