This article/blog may contain information (pictures and graphs) and also new range of terms for an eager newcomer/investor. Anyhow, I tried to simplify it.
Sifting through different financial articles/newspapers recently, I find the information about the Fed increasing (hiking) or decreasing the Fed funds rate (FFR) overloading. One must ask himself, will figuring out what FFR contribute to my financial independence?
If your answer is yes, then read through the first part of this blog. If no, scroll down to the bottom of this blog and go to the third part for the Philippines, fourth part for Hong Kong, and fifth part for India.
Personally, I would still require myself to be knowledgeable (minutely) in this topic so that I have a sense of what is going on the current financial events. Interestingly, Warren Buffett stated this on a recent Bloomberg interview, “I’ve never made a decision (investment) based on what the Fed is going to do or not do.”
First part: FFR
First question. What is this FFR?
According to Investopedia, FFR is “The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.” Too technical? Try this, “the higher the federal funds rate, the more expensive it is to borrow money.”
I guess that is the most important meaning about the FFR.
Second, who borrows and who lends? Borrower = banks, corporations and everyone else, lender = banks, the U.S. Government/governments in general. (You can observe that banks play both sides).
For simplicity, a startup business like a sari-sari store (small retail shop) cannot buy their goods to sell in their store if they do not have cash. They usually go to a funding source (bank, relatives, 5-6) to get a decent loan arrangement to start their business. These lenders would want compensation for that risk, thus interest rate is made.
Interest rate is a term that is equivalent to the term yield for investors. Dividend yield (we’ll discuss soon), bond yield, savings/checking account yield, treasury yield, etc. Usually, yields are accompanied with the symbol %. Ideally, the higher, the better.
A scenario how banks get cash to loan to businesses and other people, a person who has extra money would go to a bank and usually open a savings account seeking for a good return for their hard earned money. A person would be attracted to higher savings/checking rate whereby he’d earn some $ while doing nothing and just parking his cash in that bank and assuming no risk.
Savings and checking accounts are usually insured (NO RISK OF LOSING MONEY) by the government. That’s where you usually read or hear about the Federal Deposit Insurance Corporation (FDIC) or other similar government body that is responsible for this purpose.
Visit any local bank websites and you’d see that they insure deposits for a certain amount. Wells Fargo (United States) currently insures up to $250,000 USD, while Banco de Oro (Philippines) insures up to 500,000 Pesos. See pictures below:
Banks, in return, seek other investment opportunities (lending to a small sari-sari store hypothetically or to other less-risky businesses or loan it back to the people it serves) with higher interest rate.
Excellent example would be, a person buying his first car. Unless he can buy his car by his savings alone, he would eventually loan the money that he cannot afford at the time of purchase.
This is the current worldwide rate for car loans.
Now, this is one of the ways a bank earns its $. Let us say a person from the South East Asia (Philippines) has savings yield of 0.01% (scroll up) made a car loan at an interest of 6.5% interest all from the same bank.
Who wins in this situation?
Well, both. The individual who cannot afford a car now has a car. The bank who needs $ to pay savings yield to its cash depositors earns (MORE) and keeps the change. How much more? In this example, the difference (SPREAD) between the car loan interest and savings yield. That is 6.49% in this simple scenario. Good deal.
*Understand that I am not a banker and this is my personal view on how these banks make money of other people work for them.
Okay, so much for that lecture. I hope I did not bore you with that.
Now, FFR does not only influence car loan rates, it influences EVERYTHING that has % with it (directly-U.S. banks, indirectly-worldwide). The higher it is, the higher the car loan rates become (sadly), the higher the savings yield becomes (hopefully) and so on. (Keep in mind that each country has their own central bank that dictates their own interest rate).
So, increase in FFR is a sign of a strengthening economy, while decrease in FFR signifies the opposite.
So, who is the almighty being behind the decision of increasing or decreasing the FFR? Good question.
It is the Federal Reserve Board of Governors through the Federal Open Market Committee (FOMC). According to Google, FOMC is a committee of the Federal Reserve Board that meets regularly to set monetary policy, including the interest rates that are charged to banks.
The U.S. Federal Reserve Board of Governors has its headquarters in Washington, D.C and Janet Yellen (69 years old) is the Chair of the Board of Governors of the Federal Reserve System. Her name (I think) has been said countless times recently because of the FFR decision.
Recently, most U.S. economic indicators like the following have been recovering from the recent Great Recession of 2008. Real GDP, Institute for Supply Management’s Manufacturing PMI Index, Construction spending, unemployment rate, Full-time employment, and the stock market. See graphs below, data from BusinessInsider and FRED.
Okay, so much for graphs, if the U.S. economy has been upbeat and has a good recovery, why then the FED did not raise the interest rates last month (September 2015)?
Let us quote Janet Yellen on this,
“A lot of our focus has been on risks around China, but not just China—emerging markets more generally and how they may spill over to the U.S.,” said Fed Chairwoman Janet Yellen, noting “the significant economic and financial interconnections between the U.S. and the rest of the world.”
According to a Wall Street Journal article, even if the Fed moves rates up gradually, while other countries face dim or weakening growth prospects and more central-bank easing, economists are predicting a long period of turbulence in global markets.
Lower savings yield for everyone else in the world, thus savers would then seek other ways of improving their returns/yields. Enter stock market investing.
Well, not really, one can start his own business and be successful among other possible ways of putting your money to work. You can also lend it to your most trusted relative and not bother that your relative will pay it on time with interest.
If you do not trust your relative or do not want to lose your money from lending to anyone else, you decide for your own and seek other ways of enhancing your wealth.
Financial independence for me is when I can decide independently where to put my money to earn passively with an acceptable risk that I am willing to take. It is not when someone dictates where a stock price would be headed using a trendline.
One more added information from the Business Insider, the current level of interest rates is at its lowest since the 1930’s Great Depression.
Disclosure: I do not have shares in any of the companies mentioned in this article and don’t plan to initiate purchase within the next 24 hours. I would not receive any compensation for doing this article. I am not a professional financial analyst. This is just a hobby. Lastly, my work is not error-free, but I strive for it to be. Do not consider as a buy or sell advice. Invest at your own risk.
If you are interested in this similar approach to investing and would seek updates, I wish to invite you to this Facebook group SEEKING VALUE (https://www.facebook.com/groups/SeekingValue/?ref=bookmarks)
Part 2: S&P500, Philippine Stock Market, Hong Kong, India, and the Fed Funds Rate.
Part 3: In the Philippines, Which Company has a Good Recent Performance of Handing out Dividends.
Part 4: In Hong Kong, Which Company has a Good Recent Performance of Handing out Dividends.
Part 5: In India, Which Company has a Good Recent Performance of Handing out Dividends.
I started writing this on 9/20/2015. I allocate 2-4 hours per week to finish an article/blog.