Sam Sez

Date: Thursday, June 21, 2001

Question: "Why haven't Fed interest rate cuts helped the market and economy?"

Answer:

Because these rate cuts are not immediate substitutes for revenues and profits.

Interest rate cuts and interest rate increases impact credit and equity valuations. The most direct and seemingly immediate impact is on the bond markets and then the stock markets. Both these credit and equity markets use interest rates to value and re-value expected cash flows.

Higher interest rates reduce the prices of fixed coupon instruments whereas lower interest rates increase the prices of fixed coupon bonds.

Similarly, though on a more lagging basis, stocks generally benefit from lower interest rates because the costs of financing, both equity and debt, is reduced. This encourages re-financings and some new investments. Lower interest rates also improve operating margins because an important expense may go down.

Since January 2001, the series of interest rate cuts have not stimulated prices and security valuations because of several over-riding factors.

Some of these dominant factors are: late or no payments by companies, particularly dotcoms and technology enterprises. There was an over-building - frenzied - perhaps, of internet and other telecommunications infrastructure. The Telcos and other are now feeling the financial pain of too much debt, collapsed vendees, and over-capacity for various usage. Resistance to invest for the future and other upgrades will probably continue because the recent episode has been very costly.

Businesses grow with profits generated by revenues. For many dotcoms and the supportive industries lower interest rates will not help because there were no profits - only growing losses. In one respect equity was no substitute for profitability and now lower interest rates is no substitute (for many businesses) for revenues/profitability.

The decline in real investment in the telecommunications, internet/.com world will not be readily abated by lower interest rates since those areas are marginally pricing assets and enterprise values at levels reflecting excess and distress.

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