I knew Monday that this would be a bad week for the markets. Driving to work to start the week I heard an ad on the radio for a large regional bank. The ad touted an 8% return on new business money market accounts. Ouch!

You are probably thinking that an 8% rate on money markets is good. After all, that’s a pretty nice return with very little risk. Rates on Certificates of Deposit have been going up, too. Not many months ago CDs were paying 2%. Now the rate on CDs is creeping up toward 6%. But the rates are going up because of rising inflation and because the Federal Reserve is hiking its lending rates. In other words, the banks can pay more because they are going to be able to charge more.

The Federal Open Market Committee meets again at the end of June. This is the group that determines whether or not the Federal Reserve will raise interest rates. Right now Wall Street expects that the group will again increase rates to try to slow inflation and economic growth. Wall Street also understands that the Fed usually goes to far and ends up sending the economy into recession. I wrote a lengthy piece explaining that tendency a few weeks ago. Here is the link if you want to read it. http://www.strategisfinancial.com/newsletter/040606.htm

For anyone looking for an explanation about why the market is correcting like this now, this is probably as good as it gets. After all, GDP growth is strong, unemployment is low, and corporate earnings are good. There is no reason for stocks to be tanking. But Wall Street looks ahead and traders anticipate a major economic downturn because of Federal Reserve action.

The Fed funds rate and the discount rate impact consumers because many interest rates are linked to them. The prime rate, for example, is directly tied to the Fed rates. It is the underlying rate for most consumer rates like credit cards, home equity loans and lines of credit, auto loans, and personal loans. The prime rate is currently 8%. Consumer spending accounts for about two-thirds of U.S. economic activity. So an increase in consumer lending rates significantly impacts the economy because consumers feel less inclined to make credit purchases.

The Nasdaq has now fallen about 11% from its recent high, depending on where it ends today. The next logical support would be the October 2005 low. Right now the index is barely above its level at this time last year. In other words, a year’s worth of gains have disappeared in about seven weeks. The chart below illustrates the situation. The black line is the Nasdaq price. The gold is a 200-day moving average. The bottom sections of the chart are a momentum indicator and a Moving Average Convergence Divergence (MACD).

The downturn is hurting virtually all industry and market sectors. Over the past month about the only thing sector moving up is government bonds. Health care and utility sectors are holding their own. These are all defensive positions.

I hoped major indices would bottom about now and then rebound sharply until the FOMC meeting. Now that scenario seems less likely. I am more inclined to believe there will be sideways consolidation ahead of the meeting. The market’s direction will then be dependent on the size of the rate hike. If the Fed raises by a half point, stocks will likely fall further.

Have a great weekend.