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The Specter of Rising Rates

Suddenly, out of the blue, August’s data came in well below expectations; the economy now appears to be sputtering as we end the third quarter.  Yet the Fed has put the markets on notice that it intends to soon raise interest rates, or at least that is what the market thinks given the hawkish speeches from some Fed officials.  Raising rates into a weakening economy is ordinarily unthinkable.  As a result, after several months of unusual calmness, the equity markets threw another tantrum last week, like a child in the candy store whose mom has said the word “no,” and volatility returned.  Let’s first consider the most recent data.


Not only did August’s 151,000 new payrolls miss consensus (180,000), but the report had several negative underlying trends.  The workweek shrank from 34.4 hours to 34.3.  This is equivalent to 300,000 layoffs.  In addition, weekly earnings fell and part-time jobs were the bulk of the employment gains.

The ISM Manufacturing Index fell to 49.4 in August (anything below 50 signifies contraction) from July’s 52.6 (and disappointing the consensus view of 52.0).  ISM’s Non-Manufacturing Index, representing the bulk of the U.S. economy, fell a significant 4.1 points to 51.4 in August from 55.5 (consensus 54.9).  This is the lowest ISM reading since February 2010.

Data Dependent? You Must be Kidding!

Yet, in the face of such economic weakness, the Fed has threatened to raise rates, if not at its upcoming September 20-21 convocation, then by year’s end.  Fed Chair Yellen has consistently maintained that rate increases are “data dependent.”  I guess it depends on what data you are talking about, because data regarding economic growth and employment can’t be what they are watching.  The latest Wall Street theory is that the Fed is now worried about “financial stability.”  Could it be that the FOMC is now convinced that zero and negative rate policies have become ineffective?  Is it possible that they now see such policies as having misallocated resources within the capital markets?  Have they finally recognized that raising rates to levels where bond investors stop substituting the much more volatile and therefore risky equity market investments just makes sense?  The problem is that even if they had such thoughts, because of their “data dependency” claim, they would lose all credibility if they raised rates.  No FOMC has ever raised rates in an economy that has persistently shown the anemia that this one is currently displaying.

As I have written previously, the economy is flat because of demographic factors (baby boomer retirements and a very slow growing labor force) and poor policy (high taxes and over regulation).  Zero rate policies in Japan and Europe have resulted in significant diminishing returns as far as economic stimulus is concerned, and the length of time of such policies is having significant negative consequences for savers and for a couple of very important industries.  Such industries include insurance companies that struggle for earnings in a low rate environment, and defined benefit pension funds (those typically found in government employment) which now have a funding gap in excess of $1 trillion due to such low rates.

Market Reaction

There is no doubt that a move up in interest rates will trigger some type of equity market adjustment.  The latest volatility in the face of just some Fed talk attests to that.  Last December 16th, the day the Fed hiked the Fed Funds rate by 25 basis points (to 50 basis points total), the S&P 500 closed at 2073.07.   Two months later (February 11th), the market bottomed 11.8% lower.

As usual, back then, and likely this past week too, Wall Street shot first and then asked questions.  Last week, dividend payers, like utilities and REITs, and longer dated fixed income assets, took an initial price hit.  But here is the dirty little secret – this was based on the common misconception that when the Fed raises the Fed Funds rate (by, say 25 basis points), there is a parallel shift in the yield curve (i.e., the yield of all bond maturities, both short and long-term, also rise by 25 basis points).

In today’s world, this is not the likely outcome.  In fact, last December when the Fed initially raised its Fed Fund rate by 25 basis points, the 30 year U.S. Treasury Bond yield was near 3.0% – today it is closer to 2.5%, a fall of 50 basis points.  The same is true for the 10 year U.S. Treasury Note.  It was above 2.25% last December – today, 1.7%.  The reason: the slowdown in the world’s expected economic growth rate and the more than $12 trillion of foreign government debt (European and Japanese) that trade at negative interest rates. Because a 1.7% yielding 10 year U.S. Treasury Note looks like a huge bargain, foreign based demand will keep downward pressure on longer-term U.S. interest rates.

Sometimes, opportunity arises if adjustments are too wide or too deep.  If that same rate scenario which we saw last December plays out again, then any sell-off in dividend paying stocks and longer dated corporate debt may just turn out to be a buying opportunity.


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