To Raise or Not to Raise
To Raise or Note to Raise – The big question that has the attention of markets all over the world is, “Will the U.S. Federal Reserve raise rates in September?” We’ve discussed in both our June newsletter and July newsletter that we believe it is unlikely that the Fed will raise rates and continue to believe so. As the year goes by, the market has come around to our way of thinking. In early August the odds on a rate hike in September were 48%. By Thursday it had fallen to 32% and by the end of Friday at 27%. At this start of this week, it was down to 22%. That being said there are compelling reasons for the Fed to raise rates, so we don’t have a particularly high conviction level on our call. The Fed is made up of a bunch of human beings, and you can never be too sure about what a group of folks might do when they get together and start talking, particularly when reputations may be on the line.
The first reason many may cite for a rate increase is the significantly upwardly revised second quarter U.S. GDP estimate, from 2.3% to 3.7%. Yours truly has some, ahem, concerns with the second estimates. Without getting too wonky, remember that earlier this year, the GDP estimates for 2012 to 2014 were revised significantly lower. Problem is, if they don’t lower the estimate for current GDP, the growth rates for 2015 would have to be much higher. Think of it this way, I’ve always wanted to dunk, but at 5ft 7.5”, (don’t laugh, that 0.5 is important to me!) a hoop 10 feet high is challenging despite my orangutang-like arms, (I know mom, what can you do? I got Dad’s!). If I jump up onto a platform that is 3 feet high, I only have to reach 7 feet up to dunk. But if I jump up onto a platform that is 2 feet high, I need to spring up and reach 8 feet into the air! By revising the 3 years from 2012-2014 down, I moved from the 3 foot platform to the 2 foot, so naturally I have to jump higher. We also note that about 12% of current GDP, which translates into $2 trillion of the roughly $18 trillion, comes from a “trend” estimate, the same trend that had previously been used for the 2012-2014 growth rates prior to the downward revision. Errrh what? So they overestimated back then, but now that same trend assumption is accurate. Hmmmm… could be, but methinks it prudent to be cautiously skeptical.
We also find it ironic that various Fed Presidents have mentioned, while at the annual Jackson Hole meeting this past week,
that they are concerned with raising rates during a period of heightened market volatility. Really!? Come on! A good bit of the market’s volatility can be attributed directly to the mixed messages coming out from various members of the Fed with a rate hike both reportedly necessary and imminent while also increasingly unlikely given current conditions, depending on which official is speaking, in a bizarre monetary policy version of Schrödinger’s cat. Conventional wisdom believes that a rate hike will hurt stock prices, so naturally hearing contradictory statements like that will increase market volatility. There was a time when the Fed’s actions weren’t dependent on the stock market and vice versa – oh for a return to those simpler times!
To put the Fed’s fears in context, we’d like to point out that the S&P 500 is currently 6.7% off its all-time highs, yet some Fed officials are claiming they are uncertain about raising rates for the first time in a decade because they fear the equity markets may react negatively? To give that even more context, the S&P 500 is up almost 200% from its March 2009 lows and nearly 30% above its 2007 highs. Is the Fed telling us that the bull market needs their support? Hmmm….
What very few are talking about is what just happened with China’s devaluation of its currency and how it could affect the U.S. going forward. When China loosened its grip, its currency fell relative to the dollar more than China wanted. To stop the slide, the government sold assets and bought yuan to support the currency (a reverse QE). What asset do they have a hell of a lot of? U.S. Treasuries!
In an earlier blog post I mentioned that China had accumulated over $4 trillion in assets starting from 2003, more than all the Fed’s QE programs combined. So if/as China finds it needs to support its currency as the rest of the world sees its economy slowing and puts downward pressure on the yuan, it will need to sell more Treasuries to support its currency, and it has a lot of Treasuries along with other assets available for sale. That will increase the amount of Treasuries on the market, which will push prices down and yields up, again a reverse of what we saw in QE, as we are on the cusp of entering the era of Quantitative Tightening! I’ll have a lot more on this in the months to come.
The table below itemizes the primary arguments for and against.
What we do know is that looking over the history of the Fed, it does pay attention to the world around it. Combining current conditions with past behavior under similar circumstances, a rate hike looks unlikely. The rising U.S. dollar will likely hurt export-oriented sectors without causing the overall equity market to be harmed as importers will conversely benefit and the Fed is more likely to hold its hand. Lower bond yields coupled with a strong U.S. dollar will keep upward pressure on price to earnings ratio, (i.e. upward stock price pressures) and the drop in U.S. bond yields will help credit-sensitive sectors like housing and autos. With around 70% of the U.S. economy being driven by consumer spending, the country is better positioned to withstand the ongoing global slowdown than those economies that are more dependent on exports.
