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Federal Reserve Will Need to Hike Rates

If the recent market volatility continues, Pavlov would surmise we’ll get an accelerated chorus of stock investors clamoring for the Federal Reserve to change course, and to start cutting interest rates in order to stimulate the economy. This logic might be investor code for ‘bail out my investment account’ more than a genuine concern for the economy, but eventually the chorus will include economists, business leaders and politicians.  This has been the logic for a generation.

On December 17, 2015, the Fed started hiking the Federal Funds rate from 0.0% to where it stands today, 2.25%. Bankers are quick to remind you that Chairman Powell and the Fed are only in charge of that short-term rate and have minimal effect/control regarding longer borrowing rates. Maybe that’s not the current case.

If we get to the crossroads where the Federal Reserve is called upon to jumpstart the economy, maybe they should explore the unconventional and hike interest rates instead of cutting.

When the Federal Reserve started their tightening cycle on 12/17/15, the 10-year Treasury note stood at 2.24%. At the lowest S&P 500 close during the ‘great recession’ (3/9/2009), it stood at 2.89%. Today (12/10/18), it traded at 2.85%. In almost 10 years, and through eight interest rate hikes, the 10-year Treasury has barely moved. Bankers will also quickly remind you that a majority of lending rates are based off of the 10-year.

A new series of rate hikes would likely result in the following – a rally in 10-year treasuries resulting in lower long-term interest rates and a continued slide in the price of crude oil. Lower borrowing costs and freeing up consumer cashflow by lowering energy costs seem like a logical place to start if the economy becomes problematic. Would the yield curve invert and result in or signal a recession? We are already on the doorstep.

Side effects? Wouldn’t further rate hikes harm consumer activity by incentivizing savings over spending? When the Fed started its current tightening cycle, the Personal Savings Rate was 7.3%. The last reported figure (Oct 2018) was 6.2%. It’s not happening.

U.S. Dollar? When the tightening began, the US Dollar Index traded at 98.703. Earlier today it was 96.788. Theory would tell us that the USD should gain when we see monetary tightening. That is not following the script, and the skeptic in me hypothesizes that this rate tightening cycle may have been more about stabilizing the dollar than it truly was about putting the brakes on an overheating economy.

Yesterday’s solutions aren’t going to solve today’s problems. Ask yourself – what will the 10-year Treasury and U.S. Dollar do if the Fed resorts to the Greenspan playbook and cuts? The word that comes to my mind is murky. I really don’t think we know its effects. What if rate cuts have the unintended consequence of higher long-term interest rates due to a USD issue? This is not an easy junction we’re coming up to. Paul Volcker courageously hiked to combat inflation. Greenspan courageously slashed rates quicker and further than expected to stimulate the economy (and markets), and Powell will soon be called on to act as well. Don’t fall prey to the chorus.

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