Where Do We Stand In Anticipation Of The Fed’s Potential Interest Rate Hike? by Heli Brecailo, Gilverbook.com
Clients have asked why there’s so much coverage of the Fed’s upcoming interest rate in the media. Apart from the usual buzz every time the Federal Reserve’s authorities get together for meetings, we are about to witness a historic moment. Fed authorities are gathering for the FOMC meeting on Wed 16 and Thu 17 to decide once again about interest rates. After seven years of no change, rates – which are presently stuck at 0.25 percent – could be increased. We haven’t seen a similar situation over the past several decades. This is the first time the Fed will begin a period of interest rate hikes in nearly a decade.
What puzzles investors this time and makes this potentially one of the most controversial rate hikes is the economics metrics. Our economy has certainly come a long way from the Great Recession of 2008-09. Nevertheless, this is not a fast-growing economy where demand is wildly outpacing supply across the board and creating inflationary pressures.
Indeed, rising inflation is one of the usual signs that a central bank will raise benchmark rates. This has worked as an instrument to discourage consumption and consequently reduce inflationary pressure. However, U.S. inflation has been at very low levels over the past five years. If the Fed were to increase rates, there would have been a stronger argument for it last year. This year, the U.S. has strolled past deflation boundaries.
Oil prices, which have a significant influence on inflation, have declined and could continue to drop. A recurrent concern in the past has become quite the opposite. Although the relationship between oil prices and inflation no longer has the strength it did in the 1970’s, it remains an important indicator.
The strong dollar, which has dominated discussions in the second half of 2014 and first half of 2015, could also explain why inflation has been so tame lately. A strong dollar tends to restrain the economy by making exports more expensive and holding back growth while reducing the cost of imported goods. An important consequence is lower inflation pressure.
A collateral effect of the rising dollar has been more costly dollar-denominated debt for emerging markets, contributing to a somber mood in the international markets. Fast-growing companies that borrowed dollars rather than their local currencies might find it difficult to service debt, and can experience credit strains. Among the emerging markets, Brazil is probably the most extreme case of a stronger dollar, aggravated by a recessionary economy. Compared with the U.S. Dollar, the Brazilian Real has depreciated 40 percent over the past twelve months.
Unemployment has been another controversial point. Although we’ve seen strong numbers over the past few quarters, there’s a sentiment in the air that things aren’t quite right. If your instincts and everybody else’s are saying that people are still unemployed or underemployed, they probably are.
As in past periods of increasing employment, the U.S. seems to be approaching a trough in unemployment rates. At the current pace, unemployment will be in the four percent range by the end of next year, probably finalizing a recovery period and reaching full employment.
However, the U-6 unemployment rate—which includes discouraged workers (those who stopped looking for a job) and part-time workers—tells a slightly different story and better explains people’s negative sentiments regarding the economy. Although it is declining much as the official rate is, the U-6 is nonetheless high enough to raise doubts that we are near a full recovery.
In contrast, GDP growth works in favor of the decision to raise rates. The U.S. economy has looked good over the past five years. We seem to be at steady growth of between 2.5 and 3.0 percent of GDP. There are emerging markets not faring as well, so those growth rates seem very reasonable.
What the Fed (and probably many others) didn’t expect is that financial markets would experience the recent sell-off that shuffled things up. Driving forces from abroad can affect investor sentiment even when domestic news is either neutral or positive. Weakening of the Chinese economy, renewed concerns about Greece’s deterioration, and Brazil’s recession leading to a recent S&P credit downgrade have shaken up the markets indiscriminately.
In regards to the stocks we follow, Real Estate Investment Trusts (REITs) were hurt by the selloff like the rest of the market. Indeed, markets have been quite volatile, and REITs have been affected as much or sometimes more. However, we do not see in the real markets what we do in the financial ones. REIT stocks in general have been fundamentally sound, continuing to distribute dividends.
The August selloff works against arguments for the interest rate hike. Rather than fueling the fire, Fed authorities would potentially wait until the dust settles and make a decision when the horizon is clearer. In the end, the Fed doesn’t want to disrupt the financial markets even further and be blamed for a period of panic.
If the Fed doesn’t decide on a hike this week, it still has two other meetings in 2015—authorities are scheduled to meet on October 27-28 and December 15-16.
About the author
Heli Brecailo is the editor of GilverBook, a newsletter focused on REIT stocks. He graduated from MIT’s Sloan School of Management in 2008 and has extensive experience in managing real assets investments. He is a CFA® charterholder, and has worked in several sectors within the Financial Services Industry, including Investment Management, Investment Banking, and Commercial Banking.
Disclaimer: This is not a recommendation to buy or sell stocks. The highest-yield stocks are not necessarily the best portfolio investment choice. The purpose of this report — which is essentially a snapshot of information available on September 14, 2015 — is to reduce your stock analysis by enabling you to compare stock and sector performance. Please do your own due diligence before making any investment decision.
This report is not engaged in rendering tax, accounting, or other professional advice through this publication. No statement in this issue is to be construed as a recommendation to buy or sell any security or other investment. Some information presented in this publication has been obtained from third-party sources considered to be reliable. Sources are not required to make representations as to the accuracy of the information, however, and consequently the publisher cannot guarantee accuracy.