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What History Says About Fed Rate Hikes
Submitted by Lance Roberts of STA Wealth Management,
Yesterday, Janet Yellen gave her first post-FOMC meeting press conference. In her prepared statement, she stated exactly what was already expected:
1) accommodative policy will remain in place for a considerable amount of time after the current quantitative easing program ends this fall,
2) employment is improving,
3) the economy is recovering but has more work to do, and;
4) the current quantitative easing program would be "tapered" from $65 to $55 billion per month beginning in April.
The problem for the markets came during her press conference when she was asked what a "considerable amount of time" between the end of the current QE program and the first rate hike would be. She replied: "About six months." It took the markets about 5-seconds to understand exactly what that meant: "Rate hike in early 2015." If you want to know the precise moment that those words were uttered, just look at the chart below to see if you can figure it out.
The question is this:
"If the Fed begins to hike interest rates, what effect does that have on the economy and the markets?"
According to Jim Cramer last night, he said the idea of rising interest rates shocked the markets, however, in the long-term it's a positive sign. Rates rise as the economy does better.
The assumption he makes is that as the economy "catches fire" and corporate profits increase, then it is natural for interest rates to rise also. If a growing economy is a function of expanding profitability, then what is wrong with the chart below. (For more detail read: 50% Profit Growth)
"The chart below shows corporate profits, per the BEA, divided by GDP. (You can substitute GNP but the result is virtually identical between the two measures.)"
"The current levels of profits, as a share of GDP, are at record levels. This is interesting because corporate profits should be a reflection of the underlying economic strength. However, in recent years, due to financial engineering, wage and employment suppression and increase in productivity, corporate profits have become extremely deviated."
Cramer, also correctly states that much of the profitability increases for corporations have come from stock buybacks and cost cutting. However, many of those stock buybacks and dividend increases (as with AAPL) have been financed with low interest rate debt issuance. If rates rise, this is no longer an option. The "cash on the sidelines" story is true to some degree as total liquid assets as a percentage of total assets is near all time highs. However, corporations have relevered balance sheets to a large degree due to the cheap cost of debt. The chart below shows the ratio of cash to debt.
As far as cost cutting goes, much of that has come from reducing employment. However, as the chart below of full-time employment relative to the population shows, corporations have likely "milked that cow dry."
The problem is that the data suggests that artificially low interest rates and ongoing monetary interventions have been a key driver of both market returns and corporate profitability. However, what has been lacking is sustainable, organic, economic growth.
With this background, the consequence of a hike in overnight lending rates (Fed funds rate) will likely have far more significant impact on corporate profitability, economic growth and market returns than currently believed.
In order to support that conclusion a historical look at Federal Reserve actions can give us clues about future outcomes. The first chart below shows the fed funds rate as compared to economic growth.
What is interesting is that a case can be made that the Federal Reserve's monetary policies are potentially complicit in both economic booms and busts. When the Federal Reserve has historically begun raising interest rates the economy has slowed down, or worse. Subsequently, the Fed has to reverse its policies to restart economic growth.
It is significant that each time the Fed has lowered the overnight lending rate, the next set of increases have never exceeded the previous peak. This is due to the fact, that over the last 35 years, economic growth has been on a continued decline. I have detailed this declining trend in the Fed funds rate below as compared to the S&P 500.
Increases in interest rates are not kind to the markets either. I have highlighted, with the vertical dashed black lines, each time the Fed has started increasing the overnight lending rates. Each time has seen either market stagnation, declines, or crashes. Furthermore, it is currently implied that the Fed funds rate will increase to 3% in the future, yet the current downtrend suggests that an increase to 2% is likely all that can be withstood.
As I stated in yesterday's missive, I am currently fully allocated to the markets only because the markets are rising. However, it is important to understand investment risks are rising due to the changing fundamental environment. Rising interest rates will negatively impact earnings as borrowing costs rise, housing as mortgage costs increase, disposable incomes as debt costs rise, etc. With an economy that is nearly 70% driven by consumption there is little wiggle room for increased costs when incomes remain primarily stagnant.
My suspicion is that while Ms. Yellen stated that interest rates could rise as soon as 2015, it is possible that it will be far longer than that. That is unless we do somehow achieve an economic growth miracle starting six years into an ongoing recovery. Just because it has never happened in the past, doesn't mean it can't happen this time...right?
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Yeah, right...
My right palm says wrong.
Remember 2006??? i do.. new Fed head AND then..... BOOM!!!!!
2014=2007 Talk of soft landings, rainbows and unicorns.
2015=2008 The masses realize things aren't worth what they thought they were worth.
If we're lucky we'll get something akin to the mid 90's when bubbles weren't systemically dangerous and things were affordable without massive exponential debt. The average Joe wasn't doing so bad in 1995.
Yeah...but tax rates were insane!
"Insane"? - for which tax brackets?
Corporate profits have not been an honest indicator of economic growth for a long fucking time.....
Isn't that the truth.... The only reason corporate profits are so high is because consumers become more indebted and the corporations wont hire anyone. Sounds like a recipe for default again.
Well, that and a heaping helping of Cronyism, Lobbying, and "Regulation" wink, wink........
Cramer the guru - he is on top of the Macro/ Micro/ Fed/ Energy/ Tech/ Pharma/ Discretionary/ Financials scene, amazing guy ...
....but an entertainer FIRST. Like the clown at the circus he is right up front.
The only thing "catching phire" are the curtains. RUN FOR YOUR LIVES!
MOAR free money please!
So "Rates rise as the economy does better." Really? I surmise, therefore, that based on the way rates rose under Paul Volcker that 1979 and 1980 were gangbuster years for the economy.
Then there's the part that reads "It is significant that each time the Fed has lowered the overnight lending rate, the next set of increases have never exceeded the previous peak. This is due to the fact, that over the last 35 years, economic growth has been on a continued decline." If the increases in rates coming after the Volcker Maximum (which appear to be around 19%) and subsequent decline had exceeded the Volcker Maximum, the economy would have siezed up forthwith and Algore would never have invented carbon credits or the internet. (Not exactly QED, but take my word for it.) And my recollection of those years (1981 onward) is not one of continued decline in economic growth. Indeed, it's likely that the decline in economic growth is directly related to the growth of regulatory strangulation induced by the government. Not to mention that by 1980 the US had some serious productive competition from the rest of the world.
Pretty graphs, not much to chew on though.
Unconventional stimulative efforts by the Fed, such as ZIRP and QE, were supposed to be both temporary and targeted. They would end as soon as the green shoots took hold and the U.S. economy gained traction and pulled out of its stubborn economic rough patch.
It's taking a few years longer than expected.
The unconventional FED efforts have continued for so long and with such intensity that they are no longer considered unconventional. They're now an essential part of our Nation's economic fabric.
Print on . . . it's for the children!
CNBS Flash: Bove Bullish on Banks After Stress Tests...
nothing matters except the price of oil
So what does the fact that the 'market' gravely fears an interest rate hike tell you? No. Not you retarded Bulltards. What does it tell an honest and enquiring person?
The Najarians say buy financials. That is good enough for me.
2% short and what for long, 5%, 6%?
Better than nuthin.
You think the short rate is a scandal, the long rate is a travesty, the risk of a "black swan" huge inflation spike that would wipe out the value of any fixed equity is gigantic. Ironically the lower the rate is held, the larger this unpriced risk. Everybody knows it but nobody does anything about it. Sigh.
brought to you by new ZH. Quoting Cramer!? and other "creditable sources" Copyright ©2009-2014 ZeroHedge.com/ABC Media,
W..T..F...?
Market is "Simple Jack" and Yellen is "Ma"
Is this invasion of the body snachers? Here drink this koolaid it will clear your mind! Moar!!
As I discussed a few days ago, a rise in interest rates is the beginning of the end:
The Quantitative Easing Doomsday Device, Primed For Detonation
As part of my civil lawsuit against Deutsche Bank, I have been studying what one may call the calculus of crime - the elements of the banking system that lead to gold manipulation, elements that demand the suppression of precious metal prices as an inevitable part of the machinery of fraud. Not only the simple fraud, of insider trading, profiting from the difference between official and internal rates of exchange, but the greater fraud that keeps the banking system existent. Now that I understand the details I have become aware of what a great unexploded bomb it all is. And the primer charge is Quantitative Easing, ready to detonate at any hour.
Quantitative Easing (QE) is the system for exchanging bad banking debts with liquid currency. Bad debts include mortgage backed securities (MBS), but also certain types of government bonds that do not provide sufficient yields to protect banks from chronic shortages of currency. Most of the banks are in a state of perpetual depositor flight. Not earning any interest, due to governments' Zero Interest Rate Policy (ZIRP), depositors are leaking away, with many parties using bank accounts only for the underlying debiting systems, storing their real wealth in cash. Having studied the details, I am convinced that bank runs are not the real issue, as QE provides an almost unlimited source of liquidity. Should a bank literally run out of cash for their ATMs, then some software bug will be blamed, the bank in question will cease trading for a few days until the printing presses have rolled off enough notes to meet demand, and then the software bug declared fixed. Compensation is given to irate customers, but along with all bank fines, is simply added to the endless QE welfare bill. In a more serious run, the presses could in theory, limit printing to the higher denomination note. Terminal bank runs are therefore probably not the critical issue at the moment.
QE is often referred to, and thought of, in the singular. But of course, there are different systems worldwide. The Bank of England, for example, both holds the accounts as well as having the responsibility to print out the banknotes, in its primary role as central bank. In the USA, the Federal Reserve handles the accounts, while the US Treasury, a separate institution, is responsible for money printing. These are not trivial differences. If the MBSs underperform or too many banks rush to turn their electronic dollar positions into currency, the Federal Reserve can go bankrupt. This would result in all US banks losing both the QE pool, in addition to the assets they have already lost, transferred to the Federal Reserve's books - a deflationary vacuum bomb. The Bank of England is not so immediately vulnerable, but suffers from another problem, common to all QE systems, including that of the Federal Reserve, in that ZIRP makes it unfavourable to withdraw cash in the form of government bonds. ZIRP is not quite zero, and is somewhere between one quarter and one percent for all the various incarnations of QE. It is paid on the electronic positions held by the QE provider. Long term government bonds all offer less interest than these account positions. So what happens when interest rates go up, and the electronic positions can be redeemed in terms of bonds with significant interest rates? The answer is that the electronic positions, rated in the hundreds of billions of dollar (or pound sterling / euros), metamorph into street currency – an immense hyperinflationary explosion.
So the conclusion is this, when ZIRP ends, as it must, because ZIRP is inflationary and we are in an inflationary spiral, then QE in the USA will result in the bankruptcy of the US banks, while in the EU and the UK QE will result in hyperinflation. The financial collapse will therefore carry a precursor detonation event, the increase of interest rates, but will quite likely deliver two different forms of financial collapse. Governments, of course, can always make up their own rules, and edict the contrary type of collapse. The US may declare that the Federal Reserve can itself receive QE from the US Treasury, for example, or the Bank of England can simply refuse to undermine its own currency. In any case, the banks are finished the moment interest rates are raised by any significant degree.
There is one more conclusion, or theory, that is suggested, that gold manipulation, for the global fraudsters, is more urgent than ever. As an inflation hiding mechanism, if it were abandoned, then the absurdity and fraud of ZIRP would be instantly exposed. We can thus expect the precious metals to be hammered until the last minute. Any cessation of the suppressive mechanisms will be followed by interest rate rises, and thence Doomsday.
Exact details of each QE system is quite hard to come by, if anyone has more in depth information, please feel free to update me.
Mark Anthony Taylor – www.kingoftherepublic.com
This is not a bad write-up and avoids most of the common misconceptions about the Fed and the reserve system. The problem is at the end:
"ZIRP is not quite zero, and is somewhere between one quarter and one percent for all the various incarnations of QE. It is paid on the electronic positions held by the QE provider. Long term government bonds all offer less interest than these account positions. So what happens when interest rates go up, and the electronic positions can be redeemed in terms of bonds with significant interest rates? The answer is that the electronic positions, rated in the hundreds of billions of dollar (or pound sterling / euros), metamorph into street currency – an immense hyperinflationary explosion."
Firstly, the basic definition of interest rate rise is increasing the Fed Fund rate or IOER. Which is what Yellen was talking about on Wednesday. So the "interest on the electronic positions" will rise in tandem.
Secondly, and more importantly, this actually cannot be done without violating the reserve requirements. The whole reason why banks don't convert their Fed reserves into a big stack of USD and go buy junk bonds for extra yield right now is because of the reserve requirements. So, that's basically not going to happen. At least, not legally.
Tapering by itself is not a concern: this is the difference between "stock" and "flow". Just because tapering is happening doesn't mean that bank reserves will disappear overnight. They will just stop growing. The Fed hasn't made clear whether it intends to roll over or actually reduce its net balancesheet position. If they maintain the balancesheet at the inflated level, there will be negligible impact on the capacity of banks to continue lending and borrowing from one another.
The only real problem that can occur is a reduction in reserves, which presumably would limit the ability of banks to transact with one another. However, this reduction can only occur if the US government actually pays back its debt instead of rolling over. Anything other than paying back the debt will keep money in the system, and hence in the reserves of the Fed. Eventually all the bonds taken on by the Fed during QE can be settled out, and replaced with other assets.
I guess there's a overhanging concern about the Fed having a giant balancesheet, but there is really no impact on a practical basis anyway. Good banks will keep reserve requirement/capital requirement ratios, bad banks won't, life will go on...
From what I have studied, many of the recipients of QE have taken out 90 day T bills, rather than keep their money in the Fed. This suggests that although the IOER will rise with interest rates, the marginal difference between them, coupled with the default risk of the Fed (and other suppliers of so called risk-free QE), implies that banks would rather the assets be converted to treasuries, thus limiting the default risk to the US treasury alone.
Understated inflation, govt. increasing taxes, bad age demographics, artificially low rates, NO DAMN WAY for honest price discovery to work on anything, and Yellen says we're winding down QE and rates will rise… sure they will — when the Fed loses control.
We keep talking about rate increases as if they were ever happening. There is a shit pile of corporate cash and other cash parked collecting whatever little interest it can find. Truth to be told, nobody is able to pay more on the money unless they're pillaging and looting another planet in the universe. Good luck trying to collect 2% instead of 0.25% on the trillions in cash out there.
Rate increases will automatically bring haircuts on the debt holdings a.k.a. stealth defaults.
Yellen should read "Zero: The Biography of a Dangerous Idea" by Seife to get a healthy fear of the power of 0% interest rates.
I want 10% CD rates again! To the moon Janet - PLEASE, oh PLEASE (fuck everyone who will killed in the wake of higher interest rates. It's all about ME!!!)!!!!
Good thing Obamacare savings will increase the discretionary income of every American.. Whew... disaster averted once again....
Uh.. the fed does not raise or lower interest reates. Markets do this.
Contacting credit also contracts the economy? I am absolutely shocked.
Interest rates go up.....debt payments go way up. Government is forced to reduce spending....economy declines.....unemployment rises....more QE and lower rates.......rinse and repeat.....how can this ever end without massive default or reset?