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Why is the Fed Raising Interest Rates?

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Why Has the Fed Raised Interest Rates Again?

The federal fund rate was raise a quarter of a percentage point to 2.25% in September. 

This is the third time in 2018 that the Federal Reserve has hiked interest rates by increasing the federal fund rate. 

Looking ahead to 2019, Fed officials expect at least three more rate hikes will be necessary, as well as one in 2020.

President Trump on the increases:

  • "I think the Fed is making a mistake. They are so tight. I think the Fed has gone crazy", Trump replied after walking off Air Force One.

trump air force one

President Donald Trump is now calling the Federal Reserve "my biggest threat".

"Because the Fed is raising rates too fast. And it's independent, so I don't speak to him," Trump said in an interview with Fox Business, referring to Fed Chairman Jerome Powell.

"But I'm not happy with what he's doing, because it's going too fast. Because... you look at the last inflation numbers, they're very low."

"I'm not blaming anybody, I put him there," Trump said of Powell. "And maybe it's right, maybe it's wrong. But I put him there."

The Trade War is hurting both the Chinese and US economies. Economists almost unanimously agree that trade wars are bad.



Whilst the Trade War is hurting US farmers with the Chinese imposing their own retaliatory tariffs on US goods, President Trump is correct with regards to inflation figures and it may be too early for the Fed to start raising interest rates this quickly.

The Fed are trying to "normalise" interest rates and are trying to get to a 'neutral rate' vs the inflation rate of 2%, but there is no such thing. Inflation is still weak depsite unemployment statistics being the lowest for 50 years, although the way that unemployment statistics have changed over that period of time. 

The US Jobless rate declined to a near 50-year low of 3.7% in September. 

The number of persons employed part time for economic reasons, i.e. involuntary part-time workers, increased by 263,000 to 4.6 million in September. These individuals, who would have preferred full-time employment, are working part time because their hours have been reduced or they are unable to find full-time jobs.

The labour partcipation rate is still falling and still hasn't recovered from the Great Recession in 2008 as you can see in the chart below.


It seems that housing purchases are already slowing and inflation is only 2%. 

Labour participation rate is still down and there is no real wage inflation. In fact it is zero or negative and auto sales have also been down year-over-year for two years now.

Real wages fell to $10.76 an hour last month, that is two cents down from where it was a year ago.

This means that the only inflation coming into the market is not due to a boost in Aggregate Demand, but cost-push inflation from US tariffs on China.

The biggest supermarkets, consumer and retail brands are all warning of higher prices becasue of the 25% tariff on Chinese goods which make up the majority of purchases in the average grocery basket in the USA.

Walmart, Gap, Coca-Cola, General Motors, Macy's and other companies have all warned that tariffs could force them to raise prices on everyday consumer goods.


The Effects of Raising Interest Rates

Ok, so let's look at the effects on global trade and the US economy on a rise in interest rates in the USA.

  1. It strengthens the US Dollar, this makes imports cheaper and exports more expensive in the USA. 
  2. This means the US will have to spend more money subsidising US farmers as their exports are now more expensive due to a stronger US Dollar and increased prices from Chinese tariffs. Trump has already asked for $12 billion in aid to subsidise US farmers from the trade war. This figure will likely increase.
  3. It hurts US households. An increase in interest rates increases mortgage repayments, credit card debt repayments and auto loan repayments. 
  4. A stronger Dollar means cheaper imports, but most of the imports that US households consume come from China which now have a 25% tariff on them, so a stronger Dollar won't be enough to offset the increase in prices
  5. It hurts emerging market economies who all hold US treasuries. As the rate rises and the USD strengthens, emerging market governments need to sell more of their USD reserves to pay for US debt repayments
  6. It hurts US stock markets, but particularly Asian markets due to reason no. 5 above
  7. Attracts more buyers of US treasuries and US assets

Why the Fed Might Think Raising Interest Rates is a Good Idea

Higher yields on US assets attracts portfolio capital invested elsewhere back to the USA.

The Fed sees the economy as robust and is worried about inflation rising too much, but as seen above, this inflation is "bad inflation", i.e. higher costs of goods for US households, not "good inflation" from higher wages. 

But, the Fed might be looking at different statistics, the economy is seen as robust. They might be raising interest rates to test how the markets react, so they can model it for future federal rate hikes.

Also, they might be raising interest rates to prompt people to buy a house with a fixed low mortgage now, rather than wait for interest rate increases in future. Initially, home prices will see a quick jump as buyers who were on the fence start rushing into the market out of fear that rates will keep going up. But, again, this is a temporay band aid. 

More likely, they are doing it to cool the housing market. Over the course of time, home prices should come down as interest rates go up. As rates rise, fewer people are able to afford homes and this creates a smaller buyer pool and more inventory. You'll likely see the same home sell for less once the initial rush of buyers has come and gone.

However, we have already soon that the housing market is already cooling. So, this is unnecessary. 

US households are eating out more, which is usually a sign of a healthy economy.

Spending at restaurants and bars has soared since the early spring, rising to the highest yearly pace in 25 years. Sales of food and drinks purchased outside the home leaped 10.1% in the 12 months from August 2017 to August 2018.

However, these rates were high in both 2000 and 2008 just before the recessions. Also, this might be a temporary effect of the recent tax cuts, which were more like a shot in the arm, then the much needed structural repair of the economy.


Another reason the Fed might want to raise interest rates is to stimlate demand for their US treasuries.

Both China and Japan have been dumping US treasuries recently.

In particular, in Japan, as the cost of hedging now has crept up to 2%. It is now cheaper for the Japanese government to buy EUR denominated bonds rather than purchase US treasuries.

The Chinese have also been issuing its own USD bonds. China is selling $1.5 billion of five-year notes at 30 basis points over Treasuries, while the size for the 10-year notes was set at $1 billion at a spread of 45 basis points.


What is the Effect of a Fed Rate Hike on the Stock Market?

The increase in interest rates via a fed rate hike has different effects on stock markets around the world. But, in general, it has led to a sell off in the stock markets, but particularly the Asian stock markets.

Will Higher Interest Rates Cause Another Asian Financial Crisis?

Not at this stage. Thailand has a very robust economy with a large trade surplus. Economies like India and Indonesia are the ones to look at. But, they have mainly learned their lessons from the last Asian Financial Crisis. The Indoneisan Rupiah has slipped 9% this year due to rising interest rates in the USA.

However, with almost $120 billion remaining in foreign currency reserves and a low debt-to-GDP ratio, Indonesia’s public finances are in a pretty sound position to continue defending their currency.

You can read more here.

Why The Federal Fund Rate Increase is Probably a Mistake

You can read our points above and also Franseca Coppola's excellent article in Forbes. You can read more about Fransesca here, who is a contributor to both Forbes and the Financial Times.

Why Does a Federal Fund Rate Increase Harm Stock Markets?

An increase in interest rates means an increase in the costs to borrow money. A fed rate hike squeezes credit and since the global economy decoupled from being pegged to gold in 1971, the global economy runs on credit. Any tightening in credit means less liquidity and less money flowing into the stock markets.

As you can see from the chart below, for the last five years, with Quantative Easing (QE), credit has been loose and there has been plenty of money sloshing around which has made its way into the stock markets. 

The chart below shows long term US government treasuries (TLT), which are usually a safe haven or risk-off asset. But, as you can see in the chart below, the stock markets have been firmly in risk-on mode. Treasuries are up less than 6% over the last five years, whilst gold (GLD) has lost over 10%, whereas the S&P500 (^GSPC) is up nearly 60%. A nice healthy return on your cash if you have only been invested in US equities (the S&P500) for the last five years.  

Chart: US Stock Market, Gold and Treasuries 2013-2018


If you looked at the five year period from 2005 and you invested for only five years, your view of the markets would be very different and likely you would be a gold bug. Here you can see that the gold ETF is up 207% over five years, whereas US treasuries and US stocks stumbled along at under 3%.


Chart: US Stock Market, Gold and Treasuries 2005-2010


What Does This Mean for The Money Pouch's Strategies?

Obviously, if you had invested in gold in 2005 - 2010, your portfolio would be up 207%. If you then switched to equities for 2013 - 2018, you would have made another 60%.

However, if you got it the wrong way round and you had invested in the US stock market from 2005 - 2010, then switched to  gold from 2013 - 2018, your portfolio would be down over the 10 years. An easy mistake to make if you are working off tips from mates who have made money from particular investments in the past. You can also make similar arguments in the property markets.

What does this mean for your portfolio set up?

"Diversification and asset allocation are key"

It is important to have a "hedge", in other words, this usually means holding treasuries alongside equities. A traditional retirement portfolio set up has 60% in equities 40% in bonds, but this mix will differ depending on age.

More modern portfolio set ups may also include gold, commodities, futures funds and alternative assets such as vintage wines, art, luxury cars, watches, stamps and more recently, Bitcoin or cryptocurrencies.

For our ETF momentum strategy that we employ for clients, we often use US treasuries as a hedge, but sometimes both treasuries and equities can move in the same direction. More recently, the hedge hasn't helped that much as treasuries have been sold off even harder that US equities as interest rates rise. The hedge is not working at this moment in time until we are officially in a recession, when portfolios will move back to risk off. Instead, we are now adding some corporate bonds into our strategies as a hedge to bolster the portfolio.

The momentum portfolios can already hold treasury ETFs, gold ETFs or cash as a hedge. Hopefully, the new portfolio construct will start adding more protection and gains from the next rebalancing date.

The momentum portfolio tracks large money flows into the market rather than trying to guess where money might be going to next. This means the ship might turn slowly when reassessing asset allocations. It also does not have stop losses which can severely hamper profits. If the portfolio moves into a recession, the portfolio will start to more heavily invest in treasuries.

Click here to read more about our investment strategies.

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