On paper, central banks are responsible for two things. They decide about the supply of currency and set interest rates. If the economy is healthy the velocity of money circulation grows higher creating inflation. Raising interest rates help to cool off the overheating economy. On the other hand, if the economy is heading for a recession central banks lower interest rates to make available to society credit cheaper and stimulate spending. This helps the economy get up from its knees. This is the theory.
Historically we see that central banks kept interest rates very low not to prevent economies from apathy but to create speculative bubbles and crashes that follow them. The control over economic cycles exercised with money supply and interest rates made it possible to transfer wealth out of the middle class to the financial sector.
Interest rates and the money supply were common tools to affect cycles until 2008 when after Lehman Brothers bankruptcy central banks panicked. The sheer scale of indebtedness on every level and vastly leveraged financial sector left the global monetary system crushed.
To avoid consequences of an uncontrolled crash, nearly every central bank on this planet lowered their interest rates to near zero levels. Just like they have done it in the past. This time was different. The fear over the financial system cohesion was and is so big that a rise in interest rates of more than 1% has not happened yet leaving markets addicted to ZIRP.
ZIRP and NIRP are here with us for 8 years already. Only one bank was brave enough to hike interest rates and it was the Federal Reserve of the US. American central bank was advertising their rate hike since mid-2014. Every quarter they found a new excuse of ‘changing circumstances’ not to do it. After a year of stalling the FED’s credibility was slowly disappearing because you can manipulate people for some time but not for long.
The first time, and the only one in the last 10 years, the FED raised interest rates by 0.25% saving remnants of their face. The result was twofold. During the year before the hike USD gained over 20% vis-à-vis other currencies. Investors waiting for any upward movement of the rate moved their capital into the dollar consequentially it was strengthened. Finally when the hike was in we saw USD reaching its peaks.
In the past, in four out of five rounds of rate hikes, USD always made new records after the first hike. Later its price only fell lower. Only once dollar did not react at all. This is classic “buy the rumour, sell the facts” in its finest.
Secondly, prices of nearly all assets crumbled. Starting with equities, commodities and ending with precious metals. The beginning of this year was one of the worst in history. Despite the volatile reaction of market the FED announced four hikes. I believed throughout the whole year that there is no chance for any interest rates to go up in the US and I had many reasons you got a chance to read about.
For ten months nothing happened but the last two months gave us such chaos and amalgamation of events that I have to say that the FED has a strong case to push interest rates higher.
Yield goes up
We see an aggressive increase in yield of US Treasuries. In summer 10Y UST paid 1.35% per annum, now they pay 2.38% already. Why is this so important?
There are two kinds of interest rates:
a) Long-term – set based on the demand for bonds. If investors do not want to invest in debt of respective country they sell this state’s bonds. This makes the price to fall and yield to increase.
b) Short-term – set by the central bank. They affect a price of credit and interest rates on your deposits.
Long-term interest rates in 98% are higher than short-term rates. Problems occur when both separate by a big margin. Seeing investors get rid of bonds, just like it happened recently (increase in yield) and the central bank keeping interest rates near zero, makes the difference between two visible to much bigger group of market participants.
If your money does not produce any interest (ZIRP) and yet you can buy bonds paying 3% more, then you would buy them. Given a bad situation of the whole banking sector, big enough capital transfer could lead to a cascade of bankruptcies.
To prevent this scenario central bank has to raise interest rates to diminish the gap between benefits of deposits and bond yield.
The trust in polls was hurt after Brexit and further decimated by Trump’s win in the US election. In case polls show at least partially what investors expect, 90% of them is convinced that the FED is going to set rates higher during next FOMC on 14 December. I believe that investors already accounted for this change and prices of many assets already reached levels discounting higher rates.
During last three months USD strengthen against other currencies in anticipation of interest rate increase, just like it did in 2014.
Contrary to the dollar, precious metals moved in the opposite direction, falling since mid-August. People were leaving metals due to a possible rate hike. Ultimately, bullion performance is the best around negative interest rates (inflation rate higher than rates on deposits or bonds). The truth is that return of positive interest rates (over the rate of inflation) is nearly impossible. It does not matter how many times the central bank will change them. The real rate of inflation is going to be higher than interest rates.
Everyone expects the FED to do it. It is a major factor for Janet Yellen (Chair of the FED) in her decision-making process because any ‘surprise effect’ is disarmed. If 90% of investors believe that FED will do it, only 10% is left stunned chances of widespread panic are low.
Scenario 1 – FED pulls the trigger
If I am correct and rates will be higher before the year ends, markets will not react violently like a year before. People already accounted for that in their and their clients’ portfolios.
What came as a surprise for me is the positive effect of Trump’s win on equities. President elect wants to cut taxes (good for equities) and massively invest in infrastructure (good for equities). He has not shown how he should find money for this and real deficit for 2016 equals at least 1.3 trillion USD (7.2% GDP). Donald Trump’s plan will most definitely increase it drastically. Another bad news is the whole world selling American debt (see chart below) and with a huge deficit, it is only a matter of time when another round of official QE will start. Unofficial printing is already underway thanks to (apart from others) the Exchange Stabilization Fund. If rates are going to be higher even by 0.5% stocks could still temporarily feel safe with the probability of another QE on the horizon and climbing inflation. Negative effects of anticipated interest rate hike (bad for stocks) were marginalised by Trump’s policy announcements.
For the record, equity prices in the US are now higher than for the 90% of the last 120 years. The real rate of inflation revolves around 8-10% (Chapwood