The central bank stated on Tuesday that it will keep interest rates near zero for two more years, but it could change its mind
Tuesday afternoon, the market appeared to celebrate the Federal Reserve's latest attempt at stimulate the economy. The central bank announced that it will keep interest rates near zero through mid-2013. The major indices immediately fell: this wasn't the additional monetary stimulus that the market was hoping for. But stocks later rose, as some traders decided to treat the Fed's statement on interest rates as a promise that they could profit from. But can we trust the Fed at its word?
David D. Moenning provides a fantastic explanation at Business Insider for why the stock market soared at the end of Tuesday. Traders realized that the Fed's assertion that interest rates would be kept near zero for at least 20 months was an opportunity to lock in a "dollar-carry/risk trade." Without getting too technical, this occurs when large investors, like hedge funds, borrow dollars at a low interest rate (by short selling T-bills) to invest in a higher-yielding asset that contains more risk, like stocks. This trade became very attractive because the Fed appears to have provided some certainty for how long interest rates will be held very low.