Nine Years on, People Forget How Nasty a Rate Increase Can Be
It’s unfortunate that we have to be spending so much time on the Federal Reserve. It’s the place to start if you want to understand a lot of what’s going on in the markets. In fact, nothing is more important — but I wish that weren’t true.
I wish the central banks could go back to just being boring, opaque, marginal institutions that took care of money supply and acted as a lender of last resort instead of monstrosities that seem to manipulate and invade every corner of every market in the world. But unfortunately, that is what we have today.
When the Fed manipulates the dollar and dollar interest rates, they are directly and indirectly affecting every market in the world — equities, gold, real estate, other commodities, junk bonds, corporate debt, etc. So even though I wish it wasn’t the case, understanding what the Fed will do next is the big question.
Let’s take two scenarios: What if they raise rates? And what if they don’t?
I’ll address both of those directly but first, I’d like to give you some background to help you understand what’s behind the debate. The Fed has certainly signaled that they intend to raise rates and it’s what the markets expect.
Securities around the world are priced as if the Fed were going to raise rates. I’ve never seen anything more trumpeted and more advertised in my career. There’s good reason for that. The last time the Fed raised rates was 2006.
In terms of cutting rates, they hit bottom in late 2008 when they got to zero — and they’ve been at zero ever since. It’s been six and a half years at zero. But you have to go back two years before that to find the last time they raised rates, so it’s going on nine years at this point. That’s a long time without a rate increase and people may forget how nasty they can be.
I was in the markets in 1994 when the Fed raised rates, and it was a wipe out. That’s when we had the bankruptcy of Orange County, California, and other dealers went out of business. There was a bond market massacre.
The same thing happened in 1987. A lot of people recall the crash of October 1987 when the stock market dropped 22% in a single day. In today’s market, that would be the equivalent of over 3,000 Dow points. Imagine the market dropping not 300 points, which would get everyone’s attention, but 3,000 points. That’s what happened in October 1987. But before that, in March of 1987, there was a bond market crash. The bond market crash preceded the stock market crash by about six months.
These things can get nasty and I could say it’s been a long time since the last one. That’s why the Fed is talking so much about it. You have to go all the way back to May 2013 when the Fed was still printing money and buying bonds (long-term asset purchases as they call it) when Ben Bernanke first started talking about maybe beginning the taper.
Imagine the market dropping not 300 points, which would get everyone’s attention, but 3,000 points.
They didn’t do anything. They didn’t cut purchases and they didn’t raise rates — they just talked about it — and still the market threw a taper tantrum fit. We had the actual taper through the course of 2014. Now the taper is over, QE3 is officially over, so this thing has been really advertised for two years.
The reason rates were at zero in the first place is because the Fed was trying to pump up assets. They wanted banks and other borrowers to go out, borrow cheap money, buy houses and stocks, bid up the price of assets, and create the wealth effect. Hopefully, that would make people feel richer, they would spend more money, and the economy would get on a self-sustaining path.
That didn’t happen. The asset prices did go up, but the wealth effect did not kick in and the economy is still very weak. The Fed did not get the kind of 3.5-4% growth they were really hoping for when they started all this. I think if the Fed had it to do it over, they never would have gone down this path or at least not stayed on it this long.
They had encouraged everyone to borrow money and lever up and do maturity mismatches (borrow overnight in the repo market and go out and buy some risky asset like stocks or other assets). Because of that, they wanted to give people lots of warning that they’re going to raise rates.
If I’m a dealer, I can borrow money overnight in the repo market and go out and buy a 10-year note, which until recently was about 2%. I have zero cost to funds and I make 2% of my 10-year note, but I can leverage that trade 10-to-1 because I can get more than 90% margin in the repo market.
A 2% profit levered 10-to-1 is a 20% return on equity, so with a government security as my asset, it’s not like I have to go buy some junk bond. As long as rates were at zero, it was pretty easy to make 10%, 20^, or even 30% returns on equity with a highly leveraged trade.
You might be saying to yourself, “That sounds a little too easy; what’s the risk in the trade?” Well, there’s no credit risk in the trade because you’ve got a treasury note as your asset. The risk is that they may raise short-term rates while you’re sitting there with overnight money holding a 10-year note.
All of a sudden the overnight money gets to be more expensive, the trade is upside-down, and you’re losing money. The Fed was saying we encourage everyone to do these crazy carry trades, do these maturity mismatches, make a lot of money, and rebuild the bank balance sheet. The time will come when we’re going to raise rates, but we’re going to give you years, literally, to get out of the trade or wind it down or hedge it. Anybody who’s caught out, shame on them, as you can’t say you weren’t warned.
The Fed wants to raise rates to normalize things. They’ve been talking about it for almost two years because they want to give people plenty of warning, but the markets don’t listen so well, at least there’s always somebody who doesn’t get the message.
As I look around, there’s still a lot of leverage in the system, enormous leverage in the stock market, enormous leverage in various carry trades around the world. Chuck Prince, then CEO of Citicorp, said prior to the last world financial calamity that you have to keep dancing as long as the music’s playing. There are some people who literally either won’t listen to the Fed or don’t believe them, etc. and are still going to be in these trades.
The short answer is I expect a lot of market disruption. I think this might throw the U.S. economy into a recession because the economy is fundamentally weak. Some people have been smart enough to get out of these carry trades, at least based on the Fed’s warnings, but some people have not and will get a rude awakening.
They may have to unwind those trades quickly, and we may see a lot of liquidity pressure. We’re seeing it anyway based just on the Fed’s talk. Imagine the reality of the Fed actually raising rates for the first time in eight years.
I think we’ll have a very bumpy ride and it won’t be soft landing. Beyond that, the whole idea that the Fed would raise rates was based on a forecast that the economy was getting stronger and we sort of achieved self-sustaining growth.
Nobody in economics, nobody on Wall Street, nobody on the buy side, nobody in academia, nobody I’ve seen anywhere has a worse forecasting record than the Fed. I don’t say that out of spite or to try to embarrass anyone; it’s just a fact. Year after year after year they produce these very high growth forecasts, and every year they’re wrong. They’re not just wrong by a little bit; they’re wrong by orders of magnitude.
So when the Fed says, well, we think the economy is healthy enough for a rate increase, that’s the first sign that it’s not. Now besides that, there’s a lot of data. We’re seeing auto loan defaults go up, real wages are stagnant to down, labor force participation continues to be very low, our trade deficit is getting worse partly because of the strong dollar, emerging markets are slowing down, and China and Europe are slowing down.
I think it’s nonsense to believe that we would be closely coupled on the way up but somehow the rest of the world is going to go down and the U.S. won’t be affected by that.
Growth is weak, so not only would I expect some disruption from the rate increase simply because people don’t listen or they’re greedy or they stay in the trade too long, but I would say the Fed’s got the economy wrong and they’re going to increase rates into a very weak economy.
I would expect probably for the U.S. economy to come close to a recession, more deflation, and probably some disruption in equity markets. The one market that might rally actually is the bond market. Ten-year notes are still pretty attractive based on everything we see.
Now, that’s if they raise rates. Let’s flip that around and talk about what happens if they don’t raise rates, because that’s the other scenario. Very few people expect this outcome, but I actually don’t think they will raise rates. I’ve been saying that for about six months, and more people are jumping on board that bandwagon recently.
I did a bunch of interviews in the fall where I said I did not think the Fed would raise rates in 2015. We can debate 2016 — that’s still pretty far away — but let’s just talk about 2015.
If you go back six months just to last summer, the debate was the Fed’s definitely going to raise rates in 2015.
If you go back six months just to last summer, the debate was the Fed’s definitely going to raise rates in 2015. The only question was: would it be March or June? I was one of those saying they won’t do it. Well, here we are in January and nobody is talking about March.
Even Janet Yellen said they weren’t going to raise them in March, so now you have your April people and your June, July people, but you’re hearing more and more people say maybe it won’t be until September. Bill Gross recently said he expects it in December. What’s the difference between December 2015 and January 2016? Not much.
We’re starting to hear a lot of doubt about whether they will, in fact, raise rates. My view that they won’t is based on what I expect the data to show. I don’t have a crystal ball and I’m not sitting inside the Fed boardroom overhearing the chitchat. I’m basing this on what the Fed itself says.
They say that the decision is data-dependent. If you look at the data, it’s coming in weak. I know we had this gangbuster third-quarter GDP, but there’s a lot of noise around that and it doesn’t appear to be sustained. The fourth quarter came in a lot weaker yesterday and the first quarter 2015 may be weaker yet. We’re still not seeing any pulse in the thing that Janet Yellen pays so much attention to, which is real wages. Real wages are stagnant.
Remember that the Fed has a dual mandate that consists of trying to reduce unemployment (or create employment, depending on how you want to put it) and price stability. Sometimes those things are in conflict and they have to roll the dice on inflation a little bit in order to create jobs or other times they have to stifle job growth in order to damp down inflation.
You can’t always do both of them at once, but sometimes you can. What’s the one piece of data where both parts of the dual mandate come together? One thing you can look at that tells you something about both is real wages. If real wages are going up, that’s a leading indicator of inflation, but it also tells you that the labor market’s pretty healthy because employees cannot get a raise or demand a raise from their bosses or their companies unless the labor market’s tight.
Real wages is the number one thing Janet Yellen is looking at. Guess what? They went down; they’re still going down. There doesn’t seem to be anything indicating, at least as far as the data is concerned, that they should raise rates. I think this is just the result of bad forecasting. They always forecast stronger growth than we actually get, and by the time they catch up to the reality of their forecast, they find out that we’re nowhere near what they expected.
This is interesting because the market is set up for a rate increase. What if they don’t? I think we’ll get to the summer, the data will be lousy, the Fed will make it clear that they’re not going to raise rates anytime soon, and “patience” will just turn into “more patience,” using their new favorite buzzword. (They seem to come up with new buzzwords every six months or so!)
The Fed did QE1, QE2, QE3 part 1, QE3 part 2, then they promised to raise rates. Once it becomes clear that they’re not going to raise rates, I think the markets might think that they can never raise rates.
It wouldn’t surprise me to see QE4 in early 2016. What may happen then will be very interesting, because the stock market could actually rally on that. It won’t be rallying on fundamentals; it will be rallying on cheap money.
The market’s expecting tightening. If they get ease, at least no rate increase and the possibility of reasons to launch QE4, markets might even rally. I’m not a big stock market bull, but if the Fed doesn’t raise rates — and my expectation is they won’t — you might actually see stocks higher at the end of the year than they are now based on more free money.
I think by then the inflationary expectations will start to ratchet up, and that’s probably good for gold as well. It could be one of those periods in the second half of this year when gold and stocks go up together for the same reason, that it’s apparent the Fed has no way out of this dilemma.
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