The Fed Indicator

The Fed’s arsenal includes the Discount Rate, the Federal Funds Rate and changing Reserve Requirements.

The Federal Funds Rate is the interest rate banks can use to borrow from each other.

The Discount Rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility - the discount window. Loans are extended for a very short term (usually overnight) to depository institutions who are in a generally sound financial condition.

Quantitative Easing (QE) is used by central banks to stimulate the national economy when conventional monetary policy has become ineffective as interest rates are already at or near zero. The Fed implements quantitative easing by buying financial assets from commercial banks and other private institutions, thus creating money and injecting a pre-determined quantity into the economy.

Operation Twist was a variation of this policy and the Fed bought longer-term Treasuries and simultaneously sold shorter-dated issues it already held in order to bring down long-term interest rates.

The level of Reserve Requirements can either liberalize or restrict the ability of banks to make loans.

Calculation

Rules

Grade the Rates and Reserve Requirements separately.

(Zweig intended major policy moves in Reserve Requirements to trigger a change but the Fed has only occasionally used this tool in this way. So this model uses an effective change of at least US$1 billion.)

The score for the Discount Rate and Federal Funds Rates are averaged as Zweig suggested using just one of these rates. This average score is then added to the Reserve Requirements to give the Fed Indicator.

Although Zweig did not consider Quantitative Easing or Operation Twist, an alternative model which considers these policies is included. As Zweig’s model has a set maximum and minimum score this column is averaged with the Discount Rate and Federal Funds rate and the rounded figure is then added to the points from the Reserve Requirements to give the Fed Indicator points.

An initial cut or increase wipes out any positive or negative points not only in this tool but also in the total average score of all the Fed’s policy tools. The cell in which this occurs is marked light grey in the table.

An increase in the Discount Rate, Federal Funds Rate or Reserve Requirements is bearish.

Sell Signals

1. A hike in either one receives minus one point for that component of the Fed Indicator. It would also wipe out any positive points that might have been there at the time. The negative point remains for six months after which it becomes ‘stale’ and is discarded.

Buy Signals

1. Moves by the Fed toward easing have a greater positive impact on stock prices than the negative effect created by tightening moves. An initial cut in either of the two tools not only wipes out any negative points that may have accumulated but it also kicks in two positive points.

2. An initial cut is the first one following a rise in that component. A cut is initial if it marks the first change in that instrument in at least two years. As an initial change grows stale, one of the two points is lost six months later and the remaining point falls a year later.

3. If a second reduction were made in the discount rate, it would add one more point, for a total of three points. That point resulting from the second cut, would become stale six months later and would drop out. Third, fourth, fifth and more consecutive cuts are treated in the same way.

 

Fed Indicator

Extremely Bullish = +2 or more points

Neutral = 0 or +1 point

Bearish = -1 or –2 points

Extremely Bearish = -3 or fewer points

 

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