What It Means For Our Economy If Interest Rates Raise

I continue to believe that the main driving forces of the economy are disinflationary. These are excessive unemployment which has continued for a very long time, continuing contraction in bank lending, 50% reduction in velocity of money, no end in sight to the huge overhang of foreclosed housing and shadow inventory of housing. Further the Euro is overvalued and continues to have growing problems with default risk in its PIIGS members.

Rising commodities prices used to be symptom of rising economic activity but in the past decade commodities markets have been dominated by speculators who may have panicked about inflation and created a misleading feedback loop of rising prices. The fundamental justification for rising commodity prices is either because of China’s growth or because developed countries monetary policy will allegedly create inflation. If those reasons for being bullish about commodities are wrong then the price will crash.

John Mauldin said on Financialsense.com that we have not had 300,000 monthly new jobs growth consistently since the 1990’s and that is the rate needed to reduce unemployment to normal levels. My opinion is to ask what reason is there to think that job creation will increase to that rate while we are going through a continued gradual collapse of the shadow banking system? And since the jobless rate is the key to low inflation and low interest rates then it seems that the intractable problem of unemployment strongly hints at interest rates staying low, Japanese style for a long time, far longer than most people intuitively imagine.

Past Trends

The history of interest rate cycles is that rates go into a long term trend lasting decades. Since these large secular cycles are rare then it is hard to use data from them for statistical purposes because each cycle is unique and there have been only a few major ones. So it is not possible to assume that the cycle of downward rates has run its course and is due for a reversal.

The driver of increasing consumption was easy credit from shadow banks, made easier by inflation from 1965 to 2008. But the shadow banking system collapsed in 2008 and is partially propped up by the government but is still in the process of collapsing. The shadow banking system competed with banks and forced them to match their terms before 2008. Now that this competitor has been crippled, the banks can return to an era of reduced competition where they will not need to be as competitive in the terms and conditions of lending. So this means it will be harder for consumers and businesses to get loans, and harder for consumers to spend.

The Consequences of Raising Rates

Stock prices went up in a bubble in the past two years because of QE1 and QE2 and because of artificially low rates. News articles say that the Fed needs to raise rates to more normal levels in order to maintain credibility. In theory that is true, but only if today’s low rates are justified due to fragile economic conditions then it would be a mistake to raise rates. What happens if rates are raised by the Fed? The first thing is that margin traders in hedge funds levered up 10 to 1 would find that they can’t justify some of their trades and would sell them. This would create a wave of selling and a sudden drop in the inflated stock market. Since the market is 70% overvalued, using PE 10 and Tobin’s Q, then a sudden debt induced, margin call induced equities sell off would create downward momentum until intrinsic value was reached and the SP would trade at 900 to 1000. See “U.S. Equities are 70% overpriced”. This would drive money into bonds.

If the Fed raises short term rates this would actually give credibility to long term bonds because it would show that the Fed is trying to fight inflation, so the rates used to calculate long term bonds might not change, if the market believes that the driving forces of the economy are disinflationary. Bonds are often owned by cash based investors like wealthy people, retired people and pension funds, so they don’t rely on a low cost margin loan to buy bonds. Of course there are financial companies that borrow short and lend long term and they would be hurt by rising short term rates. Stock prices are influenced by leveraged, rapidly trading hedge funds that rely on cheap margin loans. So rising short-term rates could hurt stocks more than long term bonds. The Fed’s QE programs bought mostly bonds in the middle of the curve (maturities between 5 to 10 years), so when the Fed stops manipulating the market that may not affect very long term Treasuries, especially if the Fed misjudges and raises rates too soon.

Where Does All This Leave Our Dollar?

People inquire about the possibility of dollar devaluation and want to know what are good investments to protect from a dollar devaluation. The answer is that other countries are working hard to do competitive devaluations to keep their currency from rising against the dollar. So in preparing for the possibility of a dollar devaluation one should not get hysterical and rush into flaky overpriced investments. Rather, they should coldly view topics such as inflation or devaluation as simply another topic to carefully review, just as a stock investor should carefully review a company to see if the 10 year inflation adjusted P.E. ratio indicates the company is priced below intrinsic value. One strategy is to diversify globally with the assumption that it is very hard to predict foreign currency prices because they are influenced by sudden, dramatic asymmetric political actions rather than gradual events that occur as the business cycle changes. If the Fed raises rates that would prop up the value of the dollar. (Which implies they won’t raise rates!).

About the author

Don Martin, CFP®

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