By Stockpickr Staff
Updated at 11:45 a.m. EDT on March 25, from March 24, 2009

On March 18, the Federal Open Market Committee, led by Federal Reserve Chairman Ben S. Bernanke, voted to keep its key target interest rate at 0%, sparking a rally in stocks and a decline in the U.S dollar. Yields on the 10-year bond to decline the most they had since 1962, and gold and oil ended the day sharply higher.

A shock to the market was the statement from the FOMC that the Federal Reserve will increase the size of its balance sheet another $1.15 trillion by buying an additional $750 billion in agency mortgage-backed securities, fully backed now by government-sponsored entities Fannie Mae (FNM) and Freddie Mac (FRE), and purchasing up to $300 billion of “longer-term Treasury securities over the next six months.”

But what exactly is the Fed doing, and how does it affect the rest of us?

Let's take a look at a chart of the FOMC’s target interest rate since June 2004.


Source: FederalReserve.gov

Principally, the Federal Reserve has powers over interest rates, or at what rates banks are allowed to borrow directly from the Fed and the direction of money supply in the country. Normally the Fed meets four times a year to deicide the direction of interest rates and money supply, although it is worth noting the Fed has not changed (added or contracted) money supply in almost a decade.

The Federal Reserve’s principal tool to combat a recession is the direction of interest rates. Here are several direct and indirect effects of lower interest rates:

1. Lower interest rates equate to lower borrowing rates across the country. Cheap money spurs growth and spending.

2. Lower interest rates have an inverse affect on bonds, which may make it cheaper for companies to issue longer-dated maturities. The Barclays iShares 20+ Year Treasury Bonds (TLT) gapped 6% higher as yields dropped, while the UltraShort 20+ Year Treasury ProShares (TBT), a two-times short ETF, on the long-end of the curve fell more than 6%.

3. Lower interest rates have a positive effect on various bank rates, home mortgage rates, LIBOR and other spreads.

4. Lower interest rates steepen the yield curve, which is the relationship between current rates and the 30-year bond, making banks such as Wells Fargo (WFC) and Bank of America (BAC) more profitable.

5. Lower interest rates weaken the U.S dollar vs. other currencies, as virtually more dollars are being printed to meet current demand. The PowerShares U.S. Dollar Bearish Index (UDN) ended the day on March 18 mostly higher as the dollar fell to a two-month low, and the PowerShares US Dollar Bullish Index (UUP) fell notably as well.

6. Lower interest rates tend to induce inflation within an economic system, which explains why the SPDR Gold Shares (GLD) moved 4% higher on March 18 and god itself rallied an additional $70 per ounce the following day. On March 18, the United States Oil (USO) ETF also ended the day higher and is currently up an additional 3% as oil crosses the $53-per-barrel mark. Both oil and gold are seen as inflation hedges.

As the subprime crisis morphed into a full-blown recession, the Federal Reserve looked to expand its role in mitigating the economic crisis, increasing the size of its balance sheet by several trillion dollars starting in late 2007.

Notable programs include the backing of money market accounts; brokering the sale of Bear Sterns and Washington Mutual to JPMorgan Chase (JPM); lending AIG (AIG) $160 billion for a 79.9% controlling stake in the company; opening up commercial paper facilities, which General Electric (GE) has already used to lower its short-term borrowing costs; buying agency debt; sponsoring the term-asset-backed securities loan facility (TALF), which companies such as Ford (F) have already tapped; and affectively taking interest rates to 0%.

So what is agency debt, and why does it matter?

As the Federal Reserve buys an additional $750 billion in Fannie and Freddie mortgage-backed securities, the average American should easily expect home mortgage rates to dip well below 4.5% for a 30-year loan. Since the start of 2007, the FED has bought $1.25 trillion in mortgage-backed paper, thus directly lowering mortgage rates across the country. Lower mortgage rates allow people to refinance at lower rates, ultimately equating to more money in Americans' pockets each year.

Below is a graphical representation of the yield curve, representing yields on securities at different maturities. The general economic school of thought is that the shape of the yield curve gives an idea of future interest rate changes and economic activity.

By lowering rates to 0%, Bernanke and the Federal Reserve have created a steep yield curve that improves banks' net interest margins. This means that banks such as Goldman Sachs (GS), State Street (STT) and New York Community Bank (NYB) are able to earn additional profits on the widening of these spreads. A steep yield curve occurs when the spread between the three-month bond and the 30-year bond is greater than 300 basis points, or 3%.


Source: FederalReserve.gov

On March 24, the Federal Reserve gave additional clarity to the market, stating that it has begun making purchases of U.S Treasury securities with maturity dates of 2016 and 2019. In part because of the Federal Reserve’s additional buying, the yield on the 30-year bond fell 0.12% as prices nudged slightly higher. Generally speaking, as the price of a bond increases, its underlying yield, or coupon, decreases, creating an inverse relationship.

At midday on Wednesday, the 30-year bond was yielding 3.5%, up slightly on the day as stocks continued their two week long rally.

For more, check out the Trade Like Ben Bernanke portfolio on Stockpickr.

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