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3 Things Worth Thinking About

Tyler Durden's picture




 

Submitted by Lance Roberts of STA Wealth Management,

1. Nothing To Fear From Fed Rate Increase

There is an overwhelming consensus of opinion that the markets, and the majority of mainstream commentators, that when the Fed begins raising rates that it is a "good thing."

The primary premise behind that consensus is that the economy is now growing steady enough to absorb the impact of higher interest rates. This opinion was espoused yesterday by Kansas City Fed President Esther George who stated:

"I don't want us to be behind the curve in beginning to normalize interest rates. When you see the economy getting as close as we are to full employment, to stable inflation, it would suggest to me that the time has come to do that."

There are a couple of things worth considering at this point:

1) As I addressed previously, the economy is very closely tied to the cost of capital.  When you consider that a large chunk of corporate profitability as of late has been created through the use of cheap loans to buy back shares, rising borrowing costs make this option much less lucrative. Rising borrowing costs also directly impact the consumer spending through variable rate credit, auto sales as loan payments rise, and housing through increase mortgage payments. (The referenced article has further points on this issue)

2) With regards to the statement, on full employment there is really only one type of employment that ultimately matters which is full-time.  Part-time and temporary employment do not foster household formation, higher levels of consumer spending or increased tax revenues. The issue is that even though the unemployment rate is approaching levels of "full-employment," it has been primarily a function of the shrinking of the labor force.  As shown in the chart below, full-time employment is basically at the same level as it has been since the financial crisis as "real employment" has primarily been a function of population growth and little else.

Employment-FullTime-Population-082114-2

3) There is little evidence that current levels of inflation are stable. As I wrote in "Will The Fed Move To Soon", the decline in economic growth globally, along with increased deflationary pressures, is likely to be reflected in the domestic economy sooner than later. Furthermore, given the fact that it is highly likely that the U.S. will have another exceptionally cold winter, the reality is that current levels of inflation have been little more than a transient surge. (See: Worse Than 1930's Depression, Europe's Recession)

High-Inflation-Index-080514

There is little argument over the fact that the current economic growth rate has been "sluggish" at best and that growth has been primarily supported by the Federal Reserve's ongoing balance sheet expansion. The Federal Reserve is now going to start increasing interest rates, removing that accommodation, at a time when economic growth is at extremely low levels. The question that we must consider is whether the "patient" can survive without "life support."

4) Lastly, 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.

Fed-Funds-Table-071514

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:"

However, the IMPORTANT FACT is that the number of times the Federal Reserve has hiked interest rates without a negative economic or market impact has been exactly ZERO.

 

2. Stock Buybacks On The Decline

As discussed above, one to the impacts of rising interest rates is an increased cost of capital which makes two things MUCH less lucrative. The first, and most importantly, is the "carry trade" which has been a primary driver of asset prices over the last five years. Banks have been able to borrow capital at effectively zero, leverage it, and then buy higher yielding assets to capture the spread. This has created an immense amount of profitability for banks, in particular, in recent years.  However, higher borrowing costs significantly reduce that profitability.

Secondly, corporations have been using exceptionally low interest rates to borrow capital, not for the purposes of ramping up production and capital investments, but to buy back stock to artificially boost profits per share. The focus on share buy backs has been intense over the last couple of years as the benefits of cost cutting, employment reductions and wage suppression met their inevitable limits. Like other profitability gimmicks, share buybacks are also finite in nature. After more than two years of increased share repurchases, recent data suggests that this may be coming to an end.  As Brett Arends penned:

"U.S. corporations have been spending hundreds of billions of dollars a year buying in their own stock, simultaneously increasing the demand for the stock and reducing the supply. And this matters right now because…er…they just stopped.

 

The amount spent on share buybacks plunged by more than 20% last quarter...As SG notes, 'US corporates (have) been the major net buyer of US equity in recent years, purchasing over $500 billion of stock last year alone.' But, notes the bank, this happy trend may be drawing to a close."

The ready supply of "free capital" has been a "punch bowl" to corporations from which they have drunk deeply. According to the Federal Reserve, corporate debt has risen 27% over the past five years to $9.6 trillion. So, much for those deleveraged balance sheets and when the Federal Reservdoes increase interest rates; a major supporter of asset prices in recent years will disappear.

 

3. The Taper Effect

The team at GaveKal Capital did a great piece of research confirming something that I have discussed many times in the past which is simply that everything is tied to the Federal Reserve's liquidity interventions. 

As the Federal Reserve has begun to taper their ongoing bond purchases, now at $25 billion and expected to be eliminated by October, the effect has been felt on a host of asset classes and economic statistics from inflation to stocks.  To wit:

"...the number of stocks trading above their 200-day moving average has dropped back in line with what the taper model would suggest. If this continues to follow suit, we could see the fewest number of stocks trading above their 200-day moving average in over 2+ years."

QE-Effect-082114

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.

 

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Sat, 08/23/2014 - 12:23 | 5134272 clade7
clade7's picture

3 things worth thinking about?  Pussy, ass, and tits!

 

(Cheap shot? sure...worth at least 50 greens or reds, depending upon the personal gaiety and financial seriousness of the responders..)  Ive seen others get more with less here...

Sat, 08/23/2014 - 12:30 | 5134299 himaroid
himaroid's picture

My old boss man told me that if you cut open the top of my head a swarm of little pussies with wings would fly out.

Sat, 08/23/2014 - 14:24 | 5134593 GooseShtepping Moron
GooseShtepping Moron's picture

If the personal "gaiety" is high, there won't be much thought about pussy and tits. Ass, maybe, but not in the context in which you meant it. Thankfully I do not get that vibe from the overwhelming majority of ZHers.

On a related point that I've been intending to mention for awhile now, I am also pleasantly, happily surprised that we don't have any oafs from the Manosphere crossing over into these boards telling as all how to be alphas and pick up chicks. I guess they can't cut it in the real Fight Club. I wouldn't be the first one to observe that 'PUA' rhymes with 'gay.'

Sat, 08/23/2014 - 12:22 | 5134278 J Pancreas
J Pancreas's picture

The Fed is eager to raise rates so it can lower them again for the next recession. While most Hedgers including myself will say the country is in a depression (almost 50 million on food stamps), the Fed blew its wad over the last five years and has nothing now to combat a new technical recession.

 

Get a second residence out of the country while the dollar will still buy one. This ship is gonna crash hard when it finally does.

Sat, 08/23/2014 - 20:39 | 5135606 philipat
philipat's picture

The Fed wants to Taper but "Belgium" has other ideas...

Sat, 08/23/2014 - 12:46 | 5134347 ebworthen
ebworthen's picture

So Janet should just put the prime rate at 6% and end QE on Monday.

I agree with J Pancreas; if Wall Street says it is time to pop the bubble, the FED will comply and ramp rates.

This is what Greenspan then Bernanke did to pop the last bubble; low rates to get everyone to lever up with home equity debt or leveraged CDS/Derivative debt, then pop the fucking thing.

The big players were ready and made out like bandits, or got bailed out, or both.

Mom and Pop got the shaft.

They'll do it again.

Sat, 08/23/2014 - 12:57 | 5134370 Mr.Sono
Mr.Sono's picture

mom and pop already got shafted and now on welfare.

Sat, 08/23/2014 - 13:25 | 5134441 sleigher
sleigher's picture

When does the blood stop running out of the turnip?

Sat, 08/23/2014 - 12:46 | 5134348 assistedliving
assistedliving's picture

Thank goodness for Readers Digest.  i am so glad they published this article.  

Sat, 08/23/2014 - 12:56 | 5134363 besnook
besnook's picture

the fact remains that no one has studied the effect of inflation upon asset prices when inflation only affects the consumers able to buy assets. inflation usually sticks, helicopter ben and all that. could this be a sustainable plateau? a new base level as was formed in real estate post 70s stagflation? with regard to equities, is 15 times earnings the new base level?

 

it really is different this time. there are cause and effect relationships that have never been seen or dealt with.......except in third world, uh, excuse me, emrging market backwaters.

Sat, 08/23/2014 - 12:58 | 5134375 Temerity Trader
Temerity Trader's picture

<”The Fed is eager to raise rates so it can lower them again for the next recession”>

Absolutely! Or more correctly, they must have room to cut to ensure the masses they can quickly lower again at the first hint of more trouble.  The have achieved their goal of inflating the equity markets with the results exactly as predicted by their models. Consumers eagerly went out and borrowed money and bought stuff. The rich are euphoric. High end antiques and collectables, including rare and exotic autos sales, are off the charts with prices paid breaking all records. Their only partial failure is the housing market, but student loan forgiveness will send demand and home prices soaring. Then more granite counter tops, boats and SUVs from all the “free” money refis. The Fed believes their execution has been near perfect.  Bears have been gored and faith in Fed has NEVER been higher. Vanguard now has $3 TRILLION in their various funds thanks to the Fed.  BERK A shares have more than doubled thanks to the Fed bank.

Another war is likely soon and further government deficit spending will send MIC stocks soaring.  Congress is mostly wealthy and beholden to the bankers and oligarchy.  They will do whatever it takes to increase their personal wealth and prevent civil unrest. That mean the markets must go ever higher.

 

Sat, 08/23/2014 - 13:09 | 5134404 Consuelo
Consuelo's picture

I perceive that with a major, global geopolitical 'shift' now well in progress, that it is not only maintaining $USD supremacy at home & abroad, but perhaps even just keeping the $USD continuum as a major global currency in tact, which is really what is on the minds of those at the Fed and the Exchange Stabilization Fund.   Things can happen fast these days - a lot faster than they used to even 20 years ago.   With a global sentiment shift in progress, disruptive changes could happen faster than most think - especially those ensconced in a U.S.-centric mindset, where the Universe itself revolves around what the U.S. says and does and not much else matters.

Sat, 08/23/2014 - 13:24 | 5134435 hairball48
hairball48's picture

Still "stacking' here; fuck the Fed.

Sat, 08/23/2014 - 13:26 | 5134444 hairball48
hairball48's picture

And related: I'm an Austrian in the "gold is money" camp, not the "competing currencies" camp.

Sat, 08/23/2014 - 13:35 | 5134470 FreeMktFisherMN
FreeMktFisherMN's picture

Gold is money and the unfettered market outcome leads to this. A true gold standard is letting the market choose what money is, not some bureaucrat. So Bretton Woods was not a real gold standard. Gold does not need some bureaucrat decreeing it is money; even when it is hated and nobody but people who actually independently think about this like the Austrians do, it still is showing itself a referendum on fiat as gold is still way up as it frontran what it knew was coming with QE and still is doing a heck of a lot better than ES since the year 2k. Gold could hit 900ish and still be in the uptrend it began last decade. 

Sat, 08/23/2014 - 13:36 | 5134472 Econolingus
Econolingus's picture

Executive summary: someday markets will decline precipitously, and when they do, many people will lose money.

Sat, 08/23/2014 - 14:04 | 5134534 q99x2
q99x2's picture

It is possible that there is an error margin of 100% due to FRAUD.

Sat, 08/23/2014 - 14:04 | 5134535 brown_hornet
brown_hornet's picture

clade- I feel sorry for you if you have to worry about p a and t. I'm more worried about the Bears defense.

Sat, 08/23/2014 - 15:23 | 5134768 clade7
clade7's picture

I dont worry about it...just think about it is all.....

Sat, 08/23/2014 - 14:41 | 5134633 smcapmachine
smcapmachine's picture

Correction in 2016????? Then who gives a fuck.

Sat, 08/23/2014 - 14:57 | 5134679 saveUSsavers
saveUSsavers's picture

When CNBS brings on the Parade of Arsewholes chanting "higher rates are good" the end is near and we can only hope Kernen Claptrap of the "Suck-up To Joe Show" is the first to get AXED !

Sat, 08/23/2014 - 16:33 | 5135006 Cult of Criminality
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Mental Hopscotch

 

Speaking of    ..  .

https://www.youtube.com/watch?v=m17rt_xo9x0

Missing Persons as you may not know them..they rock, Fed don`t

Sun, 08/24/2014 - 00:50 | 5136238 roadlust
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any day now.  the meltdown will finally occur.  and ZH will be vindicated for missing the huge run up over the last six years that hasn't stopped yet.  (is there a time limit before we give up waiting for the crash?  answer: not as long as a Kenyan is in the White House.  or a woman.) 

Sun, 08/24/2014 - 13:09 | 5137270 anti-republocrat
anti-republocrat's picture

Relative to corporate debt financing stock buy-backs, when interest rates do rise, and business slackens, the interest on that debt, even at the low rates on old bonds, will become significant.  But worse, as those bonds mature, the corporation will have to refinance at higher rates.  Corporations that used actual earnings to buy back stock should be able to weather the storm.  Earnings and dividends will be far lower than interest rates, so stock prices will suffer but the corporations will survive.  Corporations that have borrowed while buying back stock will be in a world of hurt and may not survive at all.

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