Anyone doubting the influence of the US Federal Reserve (Fed) should reconsider their position after last week. The idea that the Fed would cut interest rates in the first quarter next year, and perhaps begin that program as early as next week, lit a fire under the US markets. Including last Wednesdays’ 331 point spike in the Dow Jones Industrial Average (see figure 1).

The Canadian market played along (see figure 2). Although we were hurt by weakness in the price of gold and oil, which also weakened the loonie.

On the surface, it is hard to imagine that US investors were not already convinced about Fed rate cuts. That we were reminded of same last week, hardly seems enough to spark that kind of enthusiasm we saw. Yet we did see it and will likely see it again! Bottom line; if you ignore the Fed you do so at your peril. 

Moreover, you could argue as some analysts did, that the Feds’ 25 basis point cut at the end of October actually signaled an end to the current round of cuts. It did after all, come on the heels of a 50 basis point cut in September. At the time the Fed had hinted that the US economy was in reasonably good shape despite the risks in the financial sector. 

Last week, Fed Chairman Ben Bernanke seemed to change course suggesting that when you combine a tough credit market with the housing slump and higher gasoline and heating oil prices, that maybe the consumer would feel the pinch. He then went on to say that the Fed will have to be "exceptionally alert and flexible" if it is to meet these challenges. And that was all the market needed. 

That said, after last weeks dramatic turnaround, we should see a period of consolidation. Especially if the Fed does not follow through with an actual cut this week. If the Fed does cut rates this week, that could spark another rally. Just how much of a rally will depend on the size of the cut. 

The bigger issue will be the release of information as to how the Fed intends to bail out US homeowners. There is some who believe that the Fed will negotiate a bail out package in an effort to keep the US economy out of a recession. 

The problem is that this approach creates a catch-22. This move would provide a band aid today, and will probably support stock prices… today. But in the long term, this type of move sets a dangerous precedent. It says to the investment community that you can initiate high risk strategies – which the sub-prime market clearly was – in search of a pot of gold at the end of the rainbow. And if by chance it blows up, the Fed will be there to provide a backstop the scheme, in an effort to take the path of least resistance. At some point, the cupboard is inevitably bare. 

For now, the big winners will be the US investment banks. From a couple of perspectives; 1) they will benefit from lower borrowing costs, and 2) they will be involved in a major way with any bail out plan. So traders who buy into that possibility, might want to take a serious look at some of the largest US investment banks. 

Names to consider would be Goldman Sachs (symbol GS, recent price US$226.64), Bear Stearns (symbol BSC, recent price US$99.70), Merrill Lynch (symbol MER, recent price US$59.94) and of course, Citigroup (symbol C, recent price US$33.30). Citigroup is particularly noteworthy, given the cash infusion the company recently received from Dubai. 

Still, the fact that the banks will likely lead a recovery. They will also, with perhaps the exception being GS, be one of the more volatile groups in the weeks ahead. Which is to say, you may have to suffer some pain before actually benefiting from the exposure. 

Another approach you might consider is the Canadian banking sector. For the same reasons, lower interest rates and a bottoming of the US housing crisis. The advantage of the Canadian banks is that they have much less exposure and much stronger balance sheets.