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Wednesday, 6 November, 2002, 20:45 GMT
Why rate cuts could spook the markets


Is it possible to have too much a good thing? Of course. Any wine drinker will tell you that, and so too will the stockmarkets.

Under most circumstances an interest-rate cut will be interpreted as positive news by investors in shares. The reasons are not difficult to appreciate:

a) if the return on cash is reduced, then the relative return from equities goes up

b) when the cost of borrowing goes down, corporate interest payments also go down, and companies are able to fund investment more profitably

c) lower borrowing costs mean cheaper mortgages and lower rates on credit cards, both of which stimulate consumer spending.

The logical conclusion then is: the bigger the rate cut, the greater jump in share prices.

Too much of a good thing

Right? Wrong.

Just as a wine lover can overdo the intake of claret or burgundy, markets often start to feel sick if interest rates are slashed unexpectedly.

With Amercia's central bank, the Federal Reserve, lopping 0.5% off the federal funds rate, pushing it to a four-decade low at 1.25%, nervous US investors are asking themselves:

"What is it the Fed knows that we don't? Is there some really bad news coming?"

That's why the Dow Jones initially fell 40 points, before bouncing back.

Investors who had been expecting only a quarter point cut inferred that the economy must be in worse shape than they had feared, and that the consequences of a possible conflict in Iraq could be far more damaging than they thought.

As Mitch Stapley, an investment officer from Michigan, explained: "Clearly the Federal Reserve is seeing more risk of weakness than had been apparent to us."

A half point may not seem much, but with interest rates at 1.75% (as they were before the Fed cut), a 0.5% reduction means that the overall cost of borrowing has just been diminished by 28%.

The Fed is clearly doing all it can to stimulate America's flagging economy. In being so bold, it may have spooked as many as it cheered.


Economic indicators

Fears and hopes

US Fed decisons

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