Fed in a Rate Hike Corner

The Fed has trapped itself in a rate hike corner, having told the markets for nearly a year that the economy is doing great and it will need to raise rates, soon…very soon. Now there are signs of the economy weakening, other nations are devaluing their currencies and the U.S. is still stuck in ZIRP (Zero Interest Rate Policy). We’ve hit the point where the Fed must act or lose enormous credibility.

Yesterday was the biggest one-day decline in the Dow Jones Industrials Average since 2009 after the ECB provided less stimulus than was expected. This continued the decline that began with Janet Yellen’s testimony before Congress Wednesday, which left most market watchers thinking that a rate hike is all but assured. This morning we learned that private sector job growth for November came in above consensus expectations, which will have the market fairly convinced that a rate hike is all but assured. So what is this rate hike thing all about?

Why Do We Care About the Fed Rate Hike?

The rates set by the Fed act as the building blocks for all other interest rates, from the rates on your mortgage, to your auto loan, to rates of return on CDs and even corporate bond rates. When the Fed changes its rates, the rates on everything else move up or down with it as well. If the Fed does hike rates this month, for example, home mortgage rates will rise.  However, given that the Fed rate hike isn’t expected to be much, the increase will likely be minimal.

Why are super-low, zero rates a problem?

The problem with low rates is all about risk versus return. When the Fed pushes rates really low, it makes it hard to generate a reasonable return on savings. Right now this is particularly difficult for the nation given the baby boomers, the largest generation, are either in or about to enter retirement, when they need to generate income off their savings the most.

In order to deal with the low rates, investors are forced to take on more risk than they would otherwise.  You can think of risk as the likelihood of success. The higher the probability of success, the lower the demanded rate of return – no need to pay much to get people to invest in a nearly sure thing, but a really risky venture – now that takes a bigger promise of return to attract investors. So we have all these people needing to generate income from their retirement savings and they are being forced to take on more risk than they really should because interest rates are so low.

This has some major implications for the economy:

  • Some retirees/investors will refuse to take on excess risk. This means they have to live on less as their retirement cannot provide the kind of income that as reasonable to expect years ago. So they will spend less – that impacts the economy.
  • More “risky” investments are getting money than is normal. Risky investments by definition have a higher failure rate. This means we will have a higher failure rate in the economy, which means more money lost than is normal. This also impacts the economy. More money lost, less money to spend and invest in the future.

Fed in Danger!

The next problem is the Fed has presented itself as being able to jump start the economy. The first quantitative easing problem began in November 2008 – seven years ago! If the Fed hopes to have any credibility concerning its ability to affect the economy, at some point it has to be able to say, “Look, it worked. The economy can stand on its own now!”

The Fed also faces asymmetric risk in that if the economy strengthens, it has plenty of room to hike rates, but if it weakens, there isn’t much room to maneuver as there is no evidence that negative rates at a central bank are stimulative.

The Fed has also been telling the markets for over a year that the economy was just about, almost there, oh so close… to being ready to stand on its own without the super low rates to support it. Chairwoman Janet Yellen has been telling us that she needed to see table job growth…well, we’ve been seeing at least headline job growth. (The underlying reality of the quality of the jobs is another thing entirely.)  Once again, the Fed is facing a credibility problem if they don’t raise rates here after so much lip service.
Problem is, our domestic rates are effectively being raised when other central banks around the world lower their rates.  The ECB just lowered their primary rate to NEGATIVE 0.3%.  Yup, they now charge interest on the money banks leave with them… That’s like Wells Fargo charging ME for the money I have in a savings account with them. However, the ECB didn’t lower rates as much as was expected which has given Yellen and company a much needed reprieve! Since the ECB didn’t go as negative as was expected, the dollar index actually fell over 2% yesterday for its largest single day decline since 2009.

You can almost hear Draghi, “Here’s your chance Janet, if you are ever going to do it, do it now!” Want to bet that after the Fed raises this month, the ECB will lower rates again further?

Strong Dollar Implications

With the US raising rates while other major economies are lowering rates… some to even below zero, that makes the US dollar stronger and stronger.  Now this is fantastic for traveling as an American, but it is pure hell for American businesses that sell internationally. This means they sell less and will need to look to making more of their stuff outside the US where it is cheaper.

The strengthening dollar is also a major problem for emerging markets.  Earlier we talked about how investors needed to put money in riskier stuff than normal to try and generate any sort of reasonable return. One of the places they put money was in emerging markets.  Companies in these economies figured out that Americans were desperate for returns and they could get us to invest if they sold bonds denominated in US dollars.  Given that the dollar has been falling in value since the mid 1980s, with a brief upturn around the dotcom boom/bust, these companies were confident that they could issue in USD and lower rates than in their domestic currency, but wouldn’t likely have to worry about the exchange rate changing against them.

Ooops –the dollar has been strengthening significantly, which means those bonds are becoming insanely expensive for companies in emerging markets and many will end up defaulting. Ouch!  That hurts investors, but also isn’t likely to make us a whole lot more friends around the world. An argument can easily be made that we exported the pain we would have felt from all that quantitative easing to emerging markets and now they are paying the price for us! Not helpful at a time when the US is already struggling with its international relations.

About the Author

Lenore Hawkins, Chief Macro Strategist
Lenore Hawkins serves as the Chief Macro Strategist for Tematica Research. With over 20 years of experience in finance, strategic planning, risk management, asset valuation and operations optimization, her focus is primarily on macroeconomic influences and identification of those long-term themes that create investing headwinds or tailwinds.

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