Financial Review

Countdown to Liftoff

Sinclair Noe — June 17, 2015

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DOW + 31 = 17,935
SPX + 4 = 2100
NAS + 9 = 5064
10 YR YLD – .01 = 2.31%
OIL – .22 = 59.75
GOLD + 3.60 = 1186.10
SILV + 11 = 16.22

The Fed has wrapped up its June FOMC meeting. No surprises. The economy is getting better, so they say. While the Fed says they have made “considerable progress” toward its goal of maximum employment, “the committee wants to see evidence of some further progress.” They are not hiking rates right now; they will probably hike rates in September, but don’t worry about the exact date because it will be so small and gradual you will hardly notice. That’s the quick version from the Fed.

Further wage and job gains could give Fed officials confidence that inflation, which has lingered below their 2 percent goal for three years, is likely to move higher. Growth is poised to pick up as consumers start spending a windfall from lower gasoline prices, even though that hasn’t happened yet. The economy is likely to expand at a 2.5 percent annual pace in the second quarter after shrinking 0.7 percent in the previous three months. Officials now expect the economy to grow this year between 1.8 percent and 2 percent.

Just a few months ago, in March, they had predicted growth of 2.3 percent to 2.7 percent. The contraction in the first quarter was caused in large part by temporary forces, including unusually severe winter weather and a slump in energy-industry investment brought on by lower oil prices. The Fed is aware of risks overseas, such as the slowdown in China and the danger of a Greek default. The FOMC statement has dropped explicit forward guidance and now they say rate decisions will be data dependent and will be made on a month to month basis.

And so we can conclude from this that the Fed will raise interest rates in September. Based on new economic forecasts we can anticipate two quarter-point rate rises this year but a shallower pace of increases in 2016. They maintained their projection that the benchmark rate would rise to 0.625 percent in 2015, while dropping it to 1.625 percent next year, just a little lower than their March median forecast of 1.875 percent.

The end of free money is in sight. Markets have been feeding from the Fed’s free money trough for about 7 years, and soon that will change. Money will still be cheap but not free. We know that monetary policy has been a key to market performance for the past 7 years; just overlay a chart of the Federal Reserve’s balance sheet on the S&P 500 and it is easy to see the relationship. The Fed’s influence on markets can be measured on a macro level or a micro level. On days when Yellen has spoken to markets, the stock market’s performance has typically been positive. According to analytics firm Kensho, after her last 19 speeches since becoming Fed chair, the S&P was positive 63 percent of the time with an average return of 0.24 percent. On the 10 days when the Yellen Fed issued a post meeting statement, the S&P was higher 60 percent of the time with a return of 0.19 percent. Today, the S&P was up 0.2 percent. So, how will the Fed’s moves affect the markets?

Well, free money has been a boon to debtors, and one of the biggest debtors is the government; as interest rates inch higher the government will have to pay out about $2.8 trillion more in interest over the next 10 years, according to the Congressional Budget Office. Higher interest rates will directly lead to larger budget deficits. One way to reduce the deficit is to bring in more revenue, and the best way to do that is to have more people working. If the Fed were to allow the unemployment rate to fall to 4.0 percent and remain at that level, it would lead to substantially higher tax revenue and reduced payments for unemployment benefits and other transfer programs. The cumulative difference over the 10- year budget horizon is nearly $1.9 trillion. There is still considerable debate about the positive effects of a Zero Interest Rate Policy on unemployment, but working on the idea that easy money results in more jobs, it feels like the Fed is hasty in its desire to raise rates; certainly in terms of demand growth from more workers, plus a boost in wages, plus the positive impact on the federal budget.

But it doesn’t look like the Fed will wait for 4% unemployment; and a Fed rate hike might actually hurt job seekers because a rate hike would result in a stronger dollar. Other central banks are cutting rates and expanding the money supply, weighing down their currencies. The Fed hikes, the dollar appreciates; at least that is the theory. In today’s press conference Yellen said the dollar has largely stabilized, and I suppose you could make that argument for a roller coaster that is no longer at its highest point, but the ride isn’t over just yet. A stronger dollar makes it tougher for companies to sell their goods overseas. A stronger dollar from the rate increase will boost U.S. demand for products from Asia and Europe, helping lift corporate profits in those regions; imports will be cheaper but that helps global stocks, not US multinationals.

But higher rates and a stronger dollar won’t help all global stocks; emerging markets will likely be hurt. The Fed usually gives short change to emerging markets, but they may have reason to fret about something known as “spillback”. The term, coined by the International Monetary Fund, describes the threat to U.S. output from slumping import demand in emerging markets. As the Fed pushes borrowing costs higher, capital could flee developing countries, forcing them to cancel investment and settle for slower growth. That would be the spillover. But a buyers’ strike could rebound on U.S. exports of software, machines and services, undermining domestic recovery. That would be the spillback – and it could be quite significant. If you want strong growth in the US, you need emerging market buyers. Higher borrowing costs in emerging markets and a stronger dollar would further reduce U.S. exports, and the spillback risks of Fed monetary tightening are both real and large enough to cause serious concern.

Banks will like higher interest rates because they’ll be able to profit more from making loans. That, in turn could be bad news for mortgage rates, and by extension, the housing market. The good news on mortgage rates is that the Fed will move slowly, so rates will creep higher, not a quick rise. Insurance companies also like higher interest rates, because they invest customers’ premiums to be able to cover losses with the profits from those investments. If they can realize a higher yield on those investments, that goes directly to profits. Come on, you don’t think they’re going to lower the premiums.

Free money has been a boon for borrowers, and corporations have taken advantage. American corporations issued $757 billion in debt from January through May, a record volume 12 percent higher than during the first five months of last year. Companies have been borrowing at low rates and then buying back their own shares, or paying dividends, or buying up other companies. All that will dry up as the cost of money increases. Fed policymakers have expressed concern that an accommodative monetary policy has encouraged speculation in equity markets. With the prospect of higher rates, they are effectively calling for an end to financial engineering; think of buybacks and M&A as low hanging fruit. The stock market could still go higher but companies are going to have to work harder for their returns.

The Fed’s Zero Interest Rate Policy has been a nightmare for savers. Once upon a time money market funds paid almost 5%; that was 8 years ago. And don’t expect relief from the Fed any time soon. As the Fed begins tightening, yields on all short-term instruments won’t recalibrate higher, at least not soon. Right now, short-term Treasury bill rates are locked in just a smidgen above zero, and demand is strong, in part because financial institutions are required to have a little more of a liquid and safe cushion in the event of problems like 2008. Also, if rates move higher on the longer-maturity instruments, that means losses in price for bond funds or bond ETFs. Bond markets do not respond predictably to interest rate increases. There have only been a handful of tightening cycles in the Fed’s 100-year history, and on the whole, the differences have outweighed the similarities.

And there is concern that changes in financial markets since the crisis have reduced liquidity, or the ability of sellers to find buyers. The International Monetary Fund warned in its Global Financial Stability Report in April that central banks, by pumping money into markets, were concealing the decline of private participation in those markets. They concluded that: “Markets could be increasingly susceptible to episodes in which liquidity suddenly vanishes and volatility spikes.” And when liquidity dries up and volatility spikes, investors can run for the exits. That doesn’t necessarily mean a big sell-off or a crash; that might happen if the Fed surprised the markets, but this Fed seems content to telegraph every move and then move very slowly. Of course, we never know how markets will respond, and something like a Greek default or some other event could change the storyline very quickly, but the anticipated change is likely to be a more subtle shift from offense to defense.

A quick update on Greece; Prime Minister Alexis Tsipras said he’s ready to take responsibility for rejecting the terms of a deal on aid if creditors’ demands are unacceptable. Tsipras told reporters that without a satisfactory deal, he “will assume the responsibility to say ‘the big no’ to a continuation of the catastrophic policies for Greece.” Meanwhile, a Greek government committee has issued a report that determined public debt is illegal, and anti-austerity protestors are taking to the street in Athens. Negotiations between Greece and its creditors continue tomorrow in Luxembourg.