The Finance Gourmet

Personal Financial Advice from a former Certified Financial Planner

Neutral Interest Rates

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Fed Chairman Jerome Powell made some very interesting remarks where he said he thought that interest rates were “just below” neutral.

This is bizarre on many levels.

First and foremost, neutral interest rates are perfect interest rates unless your economy is in a recession in which case you want stimulating interest rates, or if you are trying to control inflation in which case you want interest rates that have a constricting effect on the economy to stop price increases. So, if interest rates were close to neutral, and inflation was not increasing, then wouldn’t you want to keep interest rates at neutral?

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But, Powell and the rest of the Fed have been telegraphing a December rate increase as loudly as possible. In other words, event though interest rates are “just below” neutral, Powell and company want to raise them. Why?

Economy is Teetering

on the edge

The other weird bit is that everyone can see the economy is slowing down, and quickly.

Housing starts are way down. Housing sales are decreasing. Both are very much affected by higher rates.

The stock market is falling, having erased the whole year’s gains. Also, in very large part due to rising rates and their affects on customer spending and corporate profits.

Then, for added fun, the automotive industry has begun announcing big layoffs, and major plan closures. Why? Falling car sales. Anyone want to guess what makes it tough to sell a product that most buyer depend on a loan to purchase? Rising rates!

So, in other words, all of the signs point to interest rates having a negative, or constricting affect on just about every part of the economy that is sensitive to interest rates. How in the world can that possibly be construed as “neutral”.

Fed Going to Start the Recession

I’ve gotten closer and closer to saying it over the last few months, without actually saying it, because predicting things isn’t really what I do, but now I’m going to say it.

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The Fed will cause the next recession with its compulsive interest rate increases. If the December rate increase doesn’t do it, one of the ones next year will. The time for the Fed to pull back and be cautious is now. No one is sure if the inflation is real, but everyone can see that the coming slowdown is real. In that case, the prudent thing is to wait and see, but the Fed doesn’t want to wait and see, it wants to be “hawkish,” and so it will over-raise rates, and dunk the economy.

If they don’t change course, the only thing we can hope for is that the recession is light.

Market Falls, But… No Panic… yet?

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So, interesting phenomenon happening in the stock market these last few days with the S&P 500 dropping over 5% (around 1,400 points) and even dipping below its 200-day moving average. In the right circumstances, this might be the trigger of a full-on rout in the stock markets.

Here is what is missing though: panic.

Markets Down – Does Anyone Care?

I’ve been subtly (and not so subtly) hinting for about a year now that I think the Federal Reserve is too set in stone on its course to raise interest rates in the face of little to no inflationary pressure. To me, this recovery, as long as it is, doesn’t seem that strong. As such, one rate hike too many, could spell disaster.

stock market price down facebook

With this week’s market reacting poorly to rising interest rates in the bond markets, I was dusting off my “I Told You So,” posts. But, it looks like I’ll have to wait a bit longer.

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Despite the fairly big numbers in the Wall Street sell off as late, there isn’t much fear associated with it. When it comes to the economy, nothing matters more than how people FEEL about it. That’s why they try so hard to measure those feelings with thinks like sentiment indexes, and the like.

Unfortunately, measuring how one person feels is tricky, you can imagine how it is when you are trying to measure millions of investors and participants in the economy.

For my part, all I can do is measure what I see and hear around me. That’s a bit larger than it once was, thanks to social media, and websites like this one, but it still isn’t statistically valid. That being said, if you get a big enough chunk of the right people, your approximation can be just as good as the real thing.

My approximation right now has everyone looking at this current market downturn as a, “Oh, yeah. We knew that was coming sooner or later.” In other words, long-term investors, and others are shuffling their decks, but are not running for the exits. That means without another push down the hill, this MIGHT be all we see of this little downturn — a few days of market declines (albeit big ones), and then back to normal.

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If, and that is a very big IF, that’s how things go down, then turn 100% of your attention to housing. Rising rates mean rising mortgage rates, and if there is a way to pop this long-term economy, it’s to send everyone back to their bunker mentality regarding real estate.

Stocks Have Hard Day – Just Volatility, or the Recession Knocking?

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Stocks had a pretty big selloff today in response to a big drop in the bond markets.

For those of you keeping score (the baseball kind, not just the points scored), here is the way the game looks so far.

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  • US economy is still expanding, making it one of the longest economic expansions
  • The economy itself is cyclical. It ALWAYS goes up AND down. So, if it has been going up for a very long time, sooner or later, there will need to be a correction, or recession. How hard the recession ends up being is a function of how it hits. A “pop” leads to a hard (potentially shorter) recession. A “soft landing” means markets can regroup and reprice (usually with a lot of sideways movement) without shocking the system.
  • The Fed keeps raising interest rates because… well, because they want to be “hawks” and not “doves” and just for the barest of moments, the supposed “target” of 2% inflation was touched, so here comes the Fed.
  • The Fed not only keeps raising interest rates, it keeps saying it is going to raise interest rates more. One more hike this year, in December, and three next year. That’s a lot of increase.
  • The bond market is starting to notice. Why would you take on a 10-year Treasury now, when you know in a year, the rate on a 1-year Treasury might be just as high?
  • This is called a compressed yield curve. Usually, you get more reward (higher interest rate) in relation to more risk (longer holding period). These days, there hasn’t been much spread between short-term rates (the ones the Fed moves) and longer term rates like the 10-year interest rates.
  • Anyone who has ever played with a rubber ball knows that the more you squeeze it, the more it bounces back when you finally let go.
  • The yield curve has been getting squeezed more and more. The last squeeze was in September, the next one is coming in December. The bond market reacted with a boing.
  • Why Now?
    • This one is kind of fun. There was a change in tax law reporting that made big purchases before September 30 much more advantageous than purchases after.
    • Anyone who needed to buy a big chunk of 10-year Treasuries did it in September instead of October.
    • Once the big buyers moved out prices naturally fell in response (more supply, less demand).
    • Once they moved down, they triggered selling by other investors, which pushed prices lower, which triggered selling by other investors, which pushed prices lower…
  • Now, 10-year Treasury rates are higher. Higher enough that it is going to start affect mortgage interest rates, and…
  • The housing market was just starting to show signs of slowing down. Higher interest rates would turn a slight slowdown into a full bloom slowdown.

crystal ball stock market economy

Crystal Ball Time

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What happens next?

As always, predicting the future is tough. But, here goes.

In one scenario, U.S. companies are still doing just fine. Earnings are still strong. Workers still have plenty of jobs, even if pay isn’t really increasing. It’s frankly probably a good thing if housing prices aren’t rising so fast. – In this case, there will be some volatility while the markets reestablish equilibrium, but in the end, the expansion continues.

In the other scenario, U.S. companies are doing well, but not THAT well. With no more momentum toward higher stock prices, the markets stall. Yet another interest rate hike is coming and everyone reacts. Higher interest rates drive the housing market lower. Less housing, means less housing starts, which means less housing jobs. People also don’t refinance since higher rates makes it less attractive. They don’t use the equity in their house for remodels, vacations, whatever. Fewer jobs makes people less confident and they cut back on spending. That creates a hard shopping season, which tips over the retailers in the markets. Computer programs kick in and do the rest of the damage. The recession begins, once again triggered by a Federal Reserve that HAD TO raise interest rates not because the data compelled them to, but because they were “hawks”.

Which scenario is it this time?

I don’t really know, but what I do know is that Scenario 2 is coming. I just don’t know if it is now, or later.

Interest Rates Rising Into the End of the Year

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The Federal Reserve did not increase interest rates at its August 1st meeting. That was widely expected after the increase from the pervious meeting. Traditionally, the Fed tries not to raise rates in back to back meetings unless it feels like the economy is getting away from them. It allows the markets, and just as importantly, the economic data The Fed relies on to adjust to the previous hike before implementing another one.

Rate Hike In September

The Federal Reserve Bank did try and telegraph that it is currently looking at another rate hike for September. While the Fed did not raise rates, it did repeatedly say how “strong” the economy was, and how strong all the economic data was.

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And, for the first time in a long while, inflation is actually running near the Fed’s so-called target rate of 2%. While the Fed’s actions seem much more like 2 percent is a ceiling, rather than a target, recent data does suggest that inflation is running solidly near the two percent mark, so action is likely warranted.

Will Higher Rates Trigger the Recession?

Here is where things get tricky.

economy defenses

While the Federal Reserve cannot let inflation run wild, the fact is that the current expansion of the U.S. economy is coming up on “longest ever economic expansion” territory. Add to that the uncertainty of the mid-term elections in the United States, an wobbling international economy, and the thundering bull-style tariff implementations of the Trump administration, and there are a lot of winds buffeting the economy. Any one of them could knock it off course, and trigger the next recession.

Fate has a heck of sense of irony some times.

The Great Recession was arguably caused by the Federal Reserve raising rates to cool off an overheating economy powered by unrealistic real estate market reaction.

The big internet bubble pop recession was also triggered by a Fed raising rates into the “irrational exuberance” of a stock market where valuations no longer made any sense.

And, here we are, an economic expansion on its last legs with plenty of uncertainty all around and here comes the Fed with — you guessed it — a series of interest rate hikes.

Will history repeat itself?

Unfortunately, the answer is almost uncertainly yes. This next rate hike, and maybe even the next may be tolerated and absorbed into the enormity of the U.S. economy, but the Fed can’t seem to contemplate what it might be doing OTHER than fighting inflation. Other Feds preached the value of the soft-landing, but this Fed hasn’t even THOUGHT about the fact that its own actions might causes circumstances that require a soft landing.

As always, I am not a fan of market timing for long-term investors. I do encourage you to rebalance your portfolio if it has been longer than a year, and take a real hard look at your risk tolerance. In the next year or so, it is VERY likely that you will be looking at your portfolios’ expected LOSS rather than your portfolio’s expected gain.

The one thing we have going for us this time around is that no matter how much politicians have tried to ruin the progress made in securing better capitalization for banks during the Great Recession, the fact remains that most banks are in a much stronger position to help withstand the winds of a market crash this time around. That doesn’t mean it will be fun, it just won’t be a complete and total threat to our entire economic system.

In the next month I’ll be building up a series of articles on how to prepare for the imminent recession. Bailing out of the market for long-term investors is not one of the steps, but there are things you can do now. For starters, make sure the job you have is the one you want for the next few years. Finding a new job is always harder during a recession. If you’ve been thinking about moving the time is now. Just be sure that wherever you land will both be able to weather the storm, and will be willing to keep you during it. Now isn’t the time for risky, companies that might not make it.

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If you are thinking about buying a house, make sure you are not reaching for the payment. Your next raise is likely the last for a few years. Same thing with car payments, or any other payments for that matter.

If you don’t have an emergency fund, bump the priority for saving one up to the top. You just might need it soon.

Don’t panic, but be smart. Make conservative financial decisions for the next 12 months.

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