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Analyzing The Impact Of Fed Rate Hikes On Markets & Economy
Submitted by Lance Roberts of STA Wealth Management,
There has been much discussion as of late about the end of the current quantitative easing program and the beginning of the Federal Reserve "normalizing" interest rates. The primary assumption is that as interest rates normalize, the financial markets will continue to rise as economic growth strengthens. While this certainly seems like a logical assumption, is it really the case?
As I discussed in "The Great American Economic Growth Myth:"
"From 1950-1980 nominal GDP grew at an annualized rate of 7.55%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There was a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily in production and manufacturing which has a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980."
This is clearly shown to be the case in the chart below.
It is important to note in the chart above that each time the business/economic cycle slowed, interest rates never fell to a level lower than they were previously. As economic growth, while bumpy, trended higher over time; so did interest rates.
As I wrote previously, that all changed.
"However, beginning in 1980 the shift of the economic makeup from a manufacturing and production based economy to a service and finance economy, where there is a low economic multiplier, is partially responsible for this transformation. The decline in economic output was further exacerbated by increased productivity through technological advances and outsourcing of manufacturing which plagued the economy with steadily decreasing wages. Unlike the steadily growing economic environment prior to 1980; the post-1980 economy has experienced by a steady decline. Therefore, a statement that the economy has had an average growth of X% since 1980 is grossly misleading. The trend of the growth is far more important, and telling, than the average growth rate over time."
Notice that since 1980, interest rates have been in a steadily declining trend. Each increase in interest rates failed to attain a level higher than the previous peak, and each low was lower than before.
Currently, both "market bulls" and economists are ignoring the historical impact of inducing higher borrowing costs on the economy. The chart below shows the 3-month average of the effective Fed Funds rate. I have highlighted (vertical blue dashed lines) when the Fed Funds rate bottomed after a decline and turned up.
As you will notice, the effective Fed Funds rate fell sharply heading into and following recessionary periods in the economy. This is really not surprising given the fact that the Federal Reserve adjusts interest rate policy in an attempt to control the economic cycle. Unfortunately, there is no evidence that they have ever been successful in doing so.
The next chart shows the impact of rising Fed Funds versus the S&P 500. Once again I notated (vertical blue dashed lines) when rising interest rates coincided with a peak in the financial markets.
It should really come as no surprise that rising interest rates, Fed Funds or otherwise, eventually has a negative impact on the financial markets. As interest rates rise, so does the costs of operations which eventually leads to a decline in corporate profitability. As corporate profitability is reduced by higher borrowing costs, market excesses in price are eventually unwound.
As I wrote in "Why Market Bulls Should Hope Rates Don't Rise:"
"The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds. However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices has very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter."
The table below shows the history of Federal Reserve rate hikes, from the month of the first increase in the 3-month average of the effective Fed Funds rate to the onset of either a recession, market correction or both.
From this data, we can make some assumptions about the current bull market cycle if we assume that the Federal Reserve will begin hiking interest rates at the beginning of 2015.
The average number of months between the first rate hike and a recession has been 42.4 with a median of 35 months. However, if we take out the two extremely long periods of 98 months following the 1961 increase and 84 months following 1994; the average falls to just 28.6 months. Given the fact that the current economic cycle is extremely weak and, at more than 60 months, already the fifth longest Post-WWII recovery, it is likely that even 28 months is on the long end.
The average stock market correction following the first rate has occurred 21.2 months later. If the first rate hike occurs in 2015, this would put the next market correction in 2016 which would correspond with my recent analysis on the collision of the "Decennial and Presidential Cycles:"
"The statistical data suggests that the next economic recession will likely begin in 2016 with a negative market shock occurring late that year, or in 2017. This would also correspond with the historical precedent of when recessions tend to begin during the decennial cycle. As shown in the chart below the 3rd, 7th and 10th years of the cycle have the highest occurrence of recession starts."
Most importantly, the number of times that Federal Reserve has hiked interest rates without a negative economic or market impact has been exactly ZERO.
There are two important points to take away from this analysis. First, as I discussed previously, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near peaks of cyclical bull market cycles. While the analysis above suggests that the current bull market could certainly last some time longer, it is important to remember that it is "only like this, until it is like that."
The problem for most investors is that by they time they recognize the change in the underlying dynamics, it will be too late to be proactive. This is where the real damage occurs as emotionally driven, reactive, behaviors dominate logical investment processes.
The second point is far more important when performing analysis such as this:
"Past performance is no guarantee of future results."
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2016? SP500 will be at 4,000+ by then, so even a little correction to 4,600 puts us all way ahead. Come on in everyone...the water is fine!
Greed kills.
Fear kills far more effectively though.
Those that failed to see not only did the Treasury Department see the iceberg (or was it Anartica?) that Wall Street was heading headlong into in 2008 but the fact that they were fully ready, willing and able to steer that behemoth away from that Apocalypse have truly missed out on yet another epic bubble inflation.
Even I missed "year 5." Year six still looks like "Dawn of the Dead" though.
Again "if I'm running for Mayor of Detroit what am I supposed to say?" The taxpayer is only on the hook for ten trillion this go around?
Do we even have a Government right now?
The writer didn't even account for the current Taper, which was first announced about 13-14 months ago.
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This analysis ignores the fact that Quantitafve easing is never economically neutral.
Printing more currency does not concurrently print more production to back it.
Instead it leeches away the value of existing production and redistributes it to the Primary Dealers, government and othe first recipients of the newly created cash.
For the Fed to print more, is for everyone who holds currency by way of production to have less.
It is a tax. Nothing more.
In a healthy economy as the Fed leaches away the proceeds of production there is less production left to fund the next round of production, and wages. For a short term surge in such QE businesses may approach banks for additional funding so that they can compete in the bid for factors of production against those entities bidding with leached funds. In this way any expansion in Fed Base money in normally only a fraction of the total credit expansion. The rest is made up of bank loans. And the aggregate increase in credit bids up prices creating a more general price inflation.
In this case, however, both enterprise and Financial Services sector were already awash in debt. When the Fed leached away funds by printing those funds could not flow back to businesses in the form of bank loans. The banks didn't have sufficient balance sheet to lend. And businesses were already heavily indebted, and disinclined to more risk. So the funds that primary dealers absorbed went to where it could shore up balance sheets - assest and excess reserves. And the funds that went to the government bid up certain factors of production - fuel, weapons, and other things government consumes.
Businesses have been becoming relatively poorer throughout the process. Those who appear most healthy are those who have fed the most from the leached funds.
That is a market that will disappear with a true halt in QE. A raise in rates will specifically attack the markets that have been created and/or sustained by lower rates - homes, everything government, autos, consumer goods.
QE is like a sink-hole. It flow of printed funds leaches away the economic ground beneath our feet. As long as the subterranean caverns remain full, all appears normal or only a little distorted at the surface.
But when the funds dry up, the apparent economy is a hollow shell that cant support the weight of the surface, and will collapse.
That was excellent, Johns.
Your point about bank loans contributing significantly to credit expansion as the non-connected businesses compete for factors of production is especially well taken. In my humble opinion, that's the key to the whole stupid shit-show and the reason why fractional reserve lending and usury were historically considered crimes. Individuals and businesses who don't have ready access to the credit pipeline are forced to bid their hard-earned money against someone else's monopoly money, and the monopoly money will always win in a case like that. It's as if my neighbor just got a credit card with $1 billion limit and proceeded to buy up all the food in the store. If I want to be able to feed my family, I have to take out a loan myself so that I have something to bid against him with. This results in general price inflation and the expansion of debt beyond any rational limit.
Under such circumstances, money ceases to be a real representation of wealth and productive capacity, and becomes a weapon instead. It is a seige engine that allows the connected to sack and loot the unconnected who become, for lack of a better term, financially defenseless.
I still believe Janet will surprise the markets and the administration by raising rates sooner rather than later. She's not The Bernank, and she doesn't seem like she's in the mood to jack around anymore.
If she does, she'll probably meet an untimely end. Car wreck or suicide by balcony?
Rate hikes???? where? when? LOL!
In the current round, rate hikes are being called Taper. When free money disappears, costs increase.
No way, Fekete already nailed this one:
Burden of debt
http://www.safehaven.com/article/12584/growth-and-debt-is-there-a-trade-off
Ain't gonna happen without a blowout in interest rate derivatives.
.
When Fed shitstorm troopers have no noire shitropes to cling to and the last shit hawk has flown back to the shit nest, then the real shitalanche will sweep across the land.
The shit winds are coming...
Complete and utter BS. If you like zero rates you also like zero capital building, higher insurance costs and zero GDP growth as direct result of that policy.