facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast blog search brokercheck brokercheck
%POST_TITLE% Thumbnail

FED: UNINTENDED CONSEQUENCE?

Markets

As summer ends (at least in theory for those of us in Arizona), traders and investors shift their focus from vacations and family, back to school, work and financials. The biggest question this week surrounds upcoming action (or inaction) of the Fed.

A quick review of any financial website, newspaper, magazine or blog will push your focus to “the Fed.” More specifically, the ongoing guessing game of what happens next. Will the Fed raise in September? How about December? Maybe 2017?

More importantly from your viewpoint… “how will this affect my plan? What should I do?” Before we address that question, let’s review how we got here and what it means.  

The Fed has maintained rates at nearly zero since 2008. When lower rates didn’t stimulate growth, they added creativity, using tools referred to as quantitative easing (multiple rounds and variations). But still, the US and world economies continue to slug along with nominal gain in momentum.

One economist asked does the Fed need a new playbook? Interesting question…

As I completed my Economics degree back in Buffalo, NY, I questioned the common assumption used in most economic theories… “keeping all else equal (or constant).” The problem is that all else rarely, if ever, remains constant or equal. Although I understand the desire and need to test one factor at a time, even back then I realized there were unintended consequences and tradeoffs. Today, the Fed deals with the unintended consequences of low rates for a prolonged time frame. I don’t think it is much of a leap on my part to question if behind closed doors they are wondering what to do next.

In theory, lower interest rates lead to greater consumption. A lower rate decreases returns on savings, which makes consumption today an appealing substitute. In other words, “if I am not going to earn much, I might as well spend it.” In the study of economics there is always a substitute. Substituting consumption today versus saving for tomorrow (or borrowing today) should lead to growth as demand for products and services rise. Of course, lower interest rates mean lower rates of return (especially for “safe” investments). The theory assumes the increased consumption will outweigh the lower returns. Historically, that has, for the most part, worked. This must be frustrating as Fed officials debate how to jumpstart the economy.

Today… the population isn’t consuming more or at least not as much as theory would project given Fed action. With the low cost of borrowing, why aren’t we growing at a faster rate (if all else were held constant)? Rather than spend, consumers remain concerned about their future. When you are not sure of what the future holds, you focus on what is controllable. Saving more is something you can control and many are doing just that (especially certain market segments). I would argue this is creating a negative “wealth effect”, which lowers consumption.

You may remember the “Wealth Effect” that was created as investors watched the value of their houses or internet stocks increase substantially and quickly. They felt richer. When people feel richer, they tend to spend more. But, when people earn less on savings accounts, bonds, etc., they spend less because they feel “less wealthy.” It appears the negative wealth effect is stronger than the consumption substitution, but why? I don’t have data that supports my theory. It is simply my opinion, but here you go.

Emotions. There is an emotional component to earning zero (or close to it). Even if you were earning 5% in a money market and inflation was 5.5% (you would be losing .5% in real terms), there is comfort in seeing a return each month on your statement.

Long Time frame. If you look back at historical Fed Funds rates, you will notice movement (up and down, but there was movement). Since 2008, we see a flat line with a tiny blip last December. No movement creates no reason to take action. Remember when mortgage rates fell below 5%? Refinancing surged. People who were renting considered how the new rates would affect their ability to buy. In other words, there was a reason to do something and people reacted. If we expect rates to stay near zero for an extended time frame, there is no reason to take action. On a side note, wait until you see the headlines once the average 30-year fixed mortgage goes back above 5%. That ought to be interesting…

This brings us to the real question. What are the possibilities and what is the likely outcome when considering your plan’s success?

I believe we have three possibilities. The first is that the economy grows which supports higher stock returns and allows the Fed to raise rates. Second, the Fed raises rates without significant growth (they are close to their desired mandates). Third, we stay the current course.

Rates increase as economy grows. This would be the ideal solution, but based on what we see today, I would argue the least likely. With stocks at all-time highs, the market needs a reason to grow from here. In this scenario, holding stocks would be a good solution. Of course, with growth will likely come higher interest rates. If market fundamentals are growing, I believe investors would welcome a rise in rates. It would be a vote by the Fed that the economy is recovering. The fact that the Fed holds back implies the opposite thought.

Rates increase without much change in current market fundamentals. This may be the most likely choice in the near to middle term. I imagine the Fed wants rates higher. They likely would have raised rates in June if not for the fear of the Brexit vote and the bad May employment reading. We know how the market reacted to the rate hike in December (not favorably). The Fed does not want to create market volatility, but if keeping rates low creates a negative effect, shouldn’t they consider raising rates? Some think yes. I tend to agree. Stocks may struggle in this scenario. In this case, a higher allocation to fixed income (especially lower duration) would presumably lower volatility and provide resources to buy stocks at lower prices. A side benefit of this scenario may be that the public starts to believe the economy is doing better and gains confidence. As the Fed delays raising rates, are they saying that the economy is weak and can’t handle a rate increase? As I write this, I imagine Jack Nicholson yelling “You can’t handle a rate increase!” Sorry, I digress…

Stay the current course. Staying the current course is the current bet. Traders have a low likelihood of a rate increase in September (but increasing with new data) with only a slightly greater than 50% expectation year end (based on interest rate future trading). One reason the current stance is likely is that although the Fed is supposed to be free from political influence, historically, they have been hesitant to take action in close proximity to an election. If you are questioning why this is true, consider the political rhetoric if the Fed raised rates in September and the market fell 10% (similar to last rate hike). Republicans would claim the economy is suffering under the current administration. If the markets rose, the Democrats would claim they are improving the economy. Of course, either situation would be based on short term noise (if solely based on this one factor), but this is why the Fed tries to avoid raising rates prior to an election. So, we may be on hold until the December meeting. In this case, maintaining current portfolio allocation is likely the best choice.

As we move forward, the markets will continue to watch news with the goal of attempting to time the Fed’s next move. We will likely continue the path of good news is bad news (rate hike possibility increases) and bad news is good news (rate hike unlikely). Since I started writing this, two pieces of information revealed that we are likely to stay the course. On August 26th, Chairwoman Janet Yellen spoke at an event in Jackson Hole, Wyoming. Her comments led market participants to believe a rate hike in September was unlikely. Interestingly, another well followed Fed governor (Fischer) provided comments that some took as guidance that rates may rise sooner. Finally, employment numbers came out this morning (Sept 2nd). They were below expectations. Perhaps the economy isn’t growing as quickly as hoped or expected. And with that, a September rate hike is likely off the table.

As we build and review your financial plan, we continue to focus on what is within our control first, then manage the factors over which we have lesser control over. What the Fed does falls into category two. Uncertainty is not good for markets. Until we have a clearer path, we will remain cautious and beware of unintended consequences.