Dear Clients and Friends,
Anyone who has financed a car, a home, an education, or a credit card understands the basics of interest rates. It’s the cost you pay to borrow money. And, yet if you asked the average American about the Federal Reserve’s (Fed) interest rate policy you would receive a blank stare. Today the raising of interest rates by the Fed has become a hot topic for the financial media, the market, and the President. To help put this conversation into context I wanted to review a few key elements of the debate over whether the Fed is hurting or helping our economy.
Over the last decade we have experienced historically low interest rates globally. This has created some dislocations, and some of these vulnerabilities have been uncovered over the last few years. We saw emerging markets respond to the ending of the Fed’s asset purchasing program, commonly referred to as ‘quantitative easing’, with a spat of volatility. We have seen the increase in volatility that normally comes with rising rates. We have also seen dollar strengthening which is partly based on a rational decision to seek out dollar denominated assets that sport higher yields than assets in other global markets.
Today we have a rate of interest set by the Federal Reserve that is low by historical standards, currently set at 2.25%. If you look around the world you will notice that many other developed nations have even lower rates than us, and many emerging economies have much higher rates. No one knows the future of rates, not even the Fed, but the market cares about that future, so it is important to understand the implications of rates in a global context. As the Fed raises rates and unwinds its balance sheet there will be continued dislocations and further deterioration in asset prices.
Now for the confusing part of this discussion. Markets and the economy are not the same thing. Markets are forward looking, they rely upon current information to deduce the future path of asset prices. The economy is doing quite well as of this writing and all indications are for decent growth going into next year. However, the market is indicating something different; it seems to be signaling some pessimism about corporate profits and general economic conditions going into 2019. If they are both right, then we have a problem that is in need of an answer. The answer, for better or worse, is for the Fed to change course by either stopping or slowing interest rate increases and run the risk of stoking inflation.
Over the last few years many have written about this moment, where the Fed will have to “thread the needle”, and massage interest rate policy so they avert a recession but somehow keep inflation in check. I think 2019 will be that year, and the Fed will have a big role to play in how the market and the economy respond to their policy. If it sounds like I am being hyperbolic in my description of the risk that our policy makers face, please understand that the Fed has been acting in ‘uncharted territory’ for over a decade. Even the best economists and investors have been conflicted on how these policies would end, and what the final outcome would look like.
I happen to believe that the Fed will ‘blink’ as was quoted by famed interest rate Guru Jim Grant in a recent interview. What exactly Grant meant by ‘blink’ can be interpreted in a few ways, but I think he was trying to say that Fed would need to change course on interest rate policy to spare the market and economy further pain. I think at the end of 2019 we will have some answers to the uncertainties that have plagued the market for most of 2018.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All investing involves risks including loss of principal. No strategy assures success or protects against losses.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.