- Market Commentary -

February 9, 2010 (FinancialWire) — Dr. Joe Duarte (http://www.joe-duarte.com) recently noted: Shares of Wells Fargo Inc. (NYSE: WFC) are in danger of breaking to new lows. Among the general fears in the market, is the potential for higher interest rates which are generally negative for bank stocks.

Duarte added: The Federal Reserve want to raise interest rates at some point in the future. And although there is no hurry, the central bank is putting together its strategy despite some significant differences of opinion inside the institution.

Fed Chairman Ben Bernanke, fresh from a controversial, but still valid confirmation, is about to set on a difficult campaign, that of taking away the proverbial punch bowl of low interest rates from the markets and the economy. According to The Wall Street Journal, Mr. Bernanke will be using a new tool, an interest rate the Fed pays banks on money they leave on reserve at the central bank. Known as interest on excess reserves, this rate is now 0.25%. The way this new device, which Congress gave Mr. Bernanke in 2008, works is this: When the Fed is ready to tap the brakes, it plans to raise the rate paid on excess reserves, according to Fed officials in interviews and recent speeches. The higher rate would entice banks to tie up money they otherwise might lend to customers or other banks. The Fed expects such a maneuver to pull up other key short-term rates, including the federal-funds rate at which banks lend to each other overnight—long the main tool for steering the economy.

But the use of this new tool does not guarantee an easy road for the central bank, the markets, or the economy. As the Journal points out, when the Fed finally tightens it will be start the reversal of a significant amount of monetary easing, thus, extricating itself from these actions will require both skill and luck: If the Fed moves too fast, it could provoke a new economic downturn; if it waits too long, it could unleash inflation, and if it moves clumsily it could unsettle markets in ways that disrupt the nascent economic recovery. Mr. Bernanke and his colleagues are attempting to explain—both to markets and the public—that the Fed has an exit strategy in the works in order to bolster confidence in its ability to steer the economy.

What it means is that Bernanke and Fed officials are about to hit the road and start making speeches about what its plans and policies for the future will entail and how things may turn out. In the past these speeches, especially those made by Alan Greenspan, were usually market movers. Remember the famous irrational exuberance speech by Greenspan and its negative effects of the markets. So the question is whether Bernanke and his crew can communicate their goals to the markets and the economy without causing volatility even before they start to tighten. This is clearly a new experiment and one that is not without risk in and of itself.

The first test of this new potential Bernanke Effect will come on Wednesday as the Fed chief goes before Congress. It’s expected that he will begin his campaign there.

And if you’re wondering why the Fed needs a new interest rate tool, here’s the answer. According to the Journal: Because it has put so much money in the banking system, the Fed expects to find it hard to control the fed-funds rate with traditional approaches. Hence the search for alternatives. In other words, the Fed doesn’t think that it can control the money supply and market interest rates in the ways that it used to. In and of itself that’s something to consider, given the fact that the central bank has been able to do its job fairly well during past cycles.

What’s more interesting is that the Fed now wants to add a certain amount of uncertainty to when and how it will raise rates once it starts down that path. According to the Journal, Fed officials and economists don’t want to be locked into a predictable pattern of interest rate increases, as they want to have flexibility depending on the economic data available and how the economy is performing at any one time. Thus: officials are reluctant to be so predictable this time. Uncertain about the outlook for the economy and markets, they want to avoid committing to a course they might later find inappropriate. They want to keep open their options: raising rates quickly; keeping them low for a long time; boosting them and then pausing, or some other tack, depending on the economy. And here’s the clincher from the Journal: Officials are warning investors and banks to prepare for surprises.

And here are some examples of other tools that the Fed might use: One is to encourage banks to tie up money at the Fed for a set period—preventing them from lending it—in what are called term deposits. Another is to lock up funds, and thus constrain the supply of credit in short-term lending markets, by borrowing against the Fed’s large portfolio of securities holdings, in trades known as reverse repos. When the Fed borrows from the markets, it effectively takes money out of circulation and replaces it with securities from its holdings.

Duarte’s conclusion: Once the Fed starts talking about higher rates, the stock market may have to rethink its expectations for many things about the future.

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Duarte partners with the Investors Resource Center at Investrend Information (http://www.investrendinformation.com).

Duarte’s IntelligentForecasts.com (http://www.intelligentforecasts.com) provides free news coverage and analysis, and his daily articles and news summaries offer recommendations and analysis for ETFs, and individual stocks in the technology, health and biotechnology, and energy sectors. Duarte has combined expertise in health care, energy, and the effects of politics and global intelligence on the financial markets offer a unique blend of insight and information to thousands of active investors and political and intelligence aficionados around the world on a daily basis.

He is the author of: Futures And Options For Dummies, Successful Energy Sector Investing, Successful Biotech Investing and co-author of After-Hours Trading Made Easy. In early 2001, in Successful Energy Sector Investing, he correctly predicted that Venezuela’s political problems could lead to an energy crisis in the United States. He has also appeared as a weekly guest on Market Mavens Radio and has logged appearances on KNX radio in Los Angeles, Financial Sense.com radio, and Wall Street Radio.

One of CNBC’s original Market Mavens, Dr. Duarte has been writing about the financial markets since 1990. His articles and commentary have been featured on CBS Marketwatch, Barron’s, Smart Money, Medical Economics, and in Technical Analysis of Stocks and Commodities magazines. In 2003, Doctor Duarte received second place, in the professional section, of the Medical Economics Investment Challenge with a 12-month return of 42%.

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