Fed Rate Increase to Trigger Stock Crash and Bond Rally

 

Stanley Fisher, the vice chair of the Federal Reserve said “...the root cause (of stock price increases) is the hyper-accommodative monetary policy of the Federal Reserve and other central banks.” ...“at some point you cross the line from reviving markets to becoming the bellows fanning the flames… I believe we have crossed that line.”

I think that very soon the Federal Reserve will become embarrassed at ultra-low rates and become afraid that they have caused a bubble. They may decide to raise rates in a few months. But the economic recovery which is now five years old is at the typical age when it is on the eve of a recession. And recessions are often triggered by the Fed attempting to cool down inflation by raising rates.

I feel that the vast majority of investment experts, economists and government officials are swept up in the peer pressure of top 10% of society that have enjoyed a big demand for skilled professional workers. Thus what they can see first hand is a labor boom. I felt the boom too in Silicon Valley where the booming economy has resulted in severe traffic jams and shortages of qualified workers.

But to be objective one must ask what are hiring conditions like for middle-skilled people who live outside of expensive areas like Silicon Valley or Manhattan. The fact is the bottom 80% are really hurting as they experience massive outflow of jobs to low cost Emerging Market countries. Not everyone can switch from a semi-skilled blue collar worker to an engineer so that means many middle skilled people will experience declining real wages for several decades and prolonged unemployment or underemployment.

The U.S. really has two layers of people: the masses with weak jobs skills who are experiencing a generation long declining living standard and must respond by cutting demand, and the top 10 or 20% who enjoy a robust demand for highly skilled engineers, doctors, etc.

If the Federal Reserve raises rates that may result in a recession which make stocks crash and then people would pile into Treasuries. Raising short term rates would make bond investors feel the Fed cares about them and thus investors would actually like long term bonds. This has happened before where the yield curve flattens when the front end (short term rates) rise during tightening.

I feel the markets mistrusted Quantitative Easing and ignored much of the weight of the Fed’s price signals. The main type of investor who responded to Fed actions have been short term speculators who borrow at overnight maturities and invest in risk assets. Once short term rates rise they will sell off high yield risk assets thus triggering a wave of forced margin selling and further price declines.

Fed easing acts to encourage mostly short term speculation in assets that can be sold instantly in response to a margin call. Of course the Fed’s short term rates act to pull down long term mortgage bond yields that help consumers. But much of the impact of the Fed is that it encourages bubbles and encourages rapid crashes during margin calls thus leading to worse crashes than if the easy money had never occurred. The most important benefit from easing would be, hypothetically speaking, if business owners could be fooled into thinking that rates would be low forever then they could expand their business. But business people know that Fed rate cuts are very unstable and can lead to huge rate increases, thus Fed rate cuts don’t encourage business expansion. Fed cuts encourage Realtors to place more ads and hire a few clerks but they don’t encourage massive building of new factories that would create jobs.

Thus the Fed should raise rates, except that the true nature of the labor market is so fragile that it needs all the help it can get even if Fed easing only helps create a few jobs in interest rate sensitive areas like real estate, mortgages, construction, etc.

I feel that Fed members are getting nervous about the new stock bubble and will tighten soon only to find out the economy is weaker than thought. My favorite economist Lacy Hunt on 7-16-2014 said that 2014 will have about a 1% real GDP growth. At this stage of the recovery it should be 4%, and with the extreme stimulus it should be even higher. If the economy is going below stall speed and the Fed raises rates then the correct rate for the 10 year Treasury will be its old low of 1.38% or possibly 1.7%; it is now 2.54%.

If a recession starts and earnings decline then people will wake up to the PE10 ratio and stocks will go down to 1,000 for the SP, from 1,980, about a 50% decline and then level off at 1,200.

What amazes me is how economists don’t spend much time examining the change in the qualitative nature of earned income which is lower than in the past due to the market changing to one of work that is part time, overtime, commissioned, self-employment, etc.

Also I am amazed how people compare the current recovery with other ones without adjusting for the massive debt which was partly in place in the 1992 recession but not fully in place until the soft 2002 recession. Thus we have only the past 12 years as a guide to how society acts when it has too much debt. That means casual comparison to previous recessions and recoveries is wrong. The charts show a massive failure for the housing market to recover in terms of new starts. Since interest rates are low then this must be due to excessive debt or to a shaky job market. Lenders don’t like unstable types of income, so less loans are approved.

Investors need independent financial advice about the Fed’s coming mistaken and short-lived rate increase and how it will crash the stock market. I wrote an article “Best measure of labor market shows disinflation risk”.

 

 

About the author

Don Martin, CFP®

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