After this week I don’t think there is a better time to explain the relationship between fixed interest rates and the Wall Street Prime Index!  On Tuesday, the 22nd of January, 2008 the DOW Jones Industrial Average opened up down nearly 500 points.  This, in conjunction with the foreign markets tumbling the day before, sent the Federal Reserve Bank in motion to cut the Prime Interest Rate by .75%.  This was a fairly drastic move. 

As per usual, when the Fed cuts rates I normally receive phone calls from my clients asking if they should refinance because they heard that interest rates were lowered.  While it is sensible to think that this is the time to move, it’s often the opposite.  Unless you move fast……or wait a little while. 

The Fed primarily moves interest rates to control inflation or to stimulate the economy.  When they cut rates, it usually stimulates the stock market and the economy.  When they raise them it is to control inflation.  OK, I realize that this is about as entertaining as watching paint dry, but here is where it gets interesting.  So when the Fed cuts rates, the stock market usually reacts favorably because it allows businesses and the public easier access to money.  When that happens, money is moved from bonds to stocks forcing rates to go up.  However, there can be a window of opportunity in this transfer to get a good rate while the money is flowing from one side to the other.  This is typically a short lived window.  Though longer term, rates tend to go back down.  So when I was talking circles in the previous paragraph, this is why.  So to further explain this, I need to explain the relationship between Stocks and Bonds. 

OK.  Everyday the stock market and the bond market compete for the exact same dollar.  Bonds are relatively safe investment vehicles.  They do not produce massive returns, but they’re safe.  And people like safe when they’re nervous about their money.  Stocks tend to be safe over the long term, though they can be volitile at times.  There are times that fortunes can be made in stocks (actually, you can always make a fortune in stocks if you have a lot of money and know which direction the market is going, but I’ll save that for another post.)  So when people feel that they can make more money in stocks with an acceptable amount of risk they take money out of bonds and put it in the stock market.  Conversly, when they get nervous about the market, they turn around and put it back into bonds.  This can happen daily.  When there is a big swing towards bonds, fixed interest rates go down (which are the kind that effect your mortgage.)  When money is moved from bonds to the stock market, fixed rates tend to trend upwards (this is bad for your mortgage.)  The Prime rate effects your equity line, credit card, car loan, etc.  Short term rates.  It also affects the rate at which banks can borrow from the Federal Reserve.

So let me break this down:  Money in bonds, rates go down.  Money in stocks, rates go up.  If this still seems complicated, it is.  Give me a call, I love talking about this stuff!