A Quick History Lesson
History is not on the side of the FED. For the last 100 years, 85% of all recessions in the United States have been preceded by FED tightening. A typical FED policy mistake is simply raising interest rates too far too fast in a panicked reaction to rising inflation. A great example of this can be found in the 2004 to 2006 tightening, when the Fed raised short-term interest rates by 25 basis points 17 times in a row. Why would they do this? It is simply the Fed’s reaction to one of their main mandates: to control inflation.
When inflation begins to rise, or inflation expectations begin to rise, then the FED is often forced to play catch-up and they raise rates too far too fast. It takes time for the FED’s rate increases to take effect in the economy and therefore it is an extremely difficult task that the FED has to grapple with as it seeks to keep inflation under control. The FED’s job becomes even more complicated as each cycle and economic circumstance is unique. The FED also has to account for other governmental mistakes such as when Congress raised tax rates in 1932, the largest increase ever, in an attempt to balance the budget. This ended up being the death knell of many businesses, and thus the Great Depression worsened. Perhaps the recent tax decreases, with all the stimulating effects, will overheat the economy and help force the FED to act.
How We Got Here
Today, the FED has to deal with yet another new circumstance—the reversal of all of the Quantitative Easing (QE) that the FED created in an effort to stimulate the economy and keep the 2008-2010 Great Recession from becoming the second Great Depression. Regardless of your opinion on the effectiveness of QE, the fact remains that the FED purchased $3.5 trillion of U.S. Treasuries and mortgage-backed bonds in an effort to lower interest rates, lower borrowing costs for U.S. business, and provide very accommodative conditions for economic growth. Today, conditions are so accommodative that there is a fear of the economy overheating.
Last September the FED announced the timing and the pace of this QE reversal, which will very quickly reach $600 billion a year. Instead of buying bonds and reducing interest rates, the FED will now be selling $600 billion of bonds back into the market. This massive increase in supply of bonds, all else being equal, should help drive interest rates higher. We do not envy the FED as it navigates this delicate balance between an overly stimulating policy exemplified by QE and the exceptionally low interest rate environment versus the normalization of FED policy. To us, the main issue will be time. If the FED moves too quickly, it risks driving the economy into a recession. If they move too slowly, then rampant inflation, or even stagflation, could occur. What the markets are fearing today is either one of these scenarios.
How it’s Playing Out So Far
Perhaps yesterday, February 21, was an interesting microcosm that illustrates all of the cause and effect of the rising rate fears. Yesterday, the FED released its minutes from its previous meeting. To summarize, the FED increased its GDP growth forecasts, acknowledged the fiscal stimulus of the recent tax cuts, and went on to suggest that their rate hikes might continue for an extended period and, most importantly, at a steeper pace. Needless to say, this spooked the stock, bond, commodity and currency markets. Let’s start with how the U.S. bond market reacted:
10 Year U.S. Treasury Yields
As you can see, there was a sudden and sharp rise in bond yields (above), which sent the U.S. Dollar (USD) sharply higher (below). The USD spiked because capital across the globe constantly seeks the highest returns with the least risk. As U.S. interest rates rise, capital from other nations and other asset classes will flow into bonds (denominated in U.S. currency) seeking the now higher, and extremely low risk, returns.
U.S. Dollar Spot Index
As rates rise, U.S. bonds become more attractive relative to stocks and commodities. Stocks also react negatively to the concept of increased borrowing costs and thus lower profit margins. To wit, after the FED released its minutes yesterday, the Dow Jones Industrial Average dropped 500 points in reaction. Below shows the similar reaction of the S&P 500® Index.
S&P 500® Index
All commodities are priced and traded in USD and therefore there is an inverse relationship between the USD and commodities. All else being equal, when the USD strengthens, commodity prices fall. The following shows how the gold market reacted to the FED minutes, the prospect of higher rates, and a stronger USD:
Gold Spot Pricing
It never ceases to amaze me how simple these relationships can be because they are often complicated by a myriad of other economic, geopolitical and additional factors that constantly interact. We do not pretend to know how any of these markets will adjust over short periods of time. We do, however, share the concern that the FED will make a policy mistake, and that their actions will have far-reaching effects on the global economy and global markets. At this point we see no need to take any action, but rather we think it’s prudent to understand and acknowledge the fundamental roots of the fears that rising inflation and interest rates bring to us all.
For more information on the state of the bond markets and the FED's actions: