Why You Should Keep On Dancing Despite Rising Interest Rates

The final and deciding State of Origin game takes place at Suncorp Stadium in Brisbane tonight.

As a long suffering NSW Blues supporter, I can’t help hijacking today’s Money Morning for a brief moment to send out positive vibes for a victory in enemy territory.

State of Origin is without doubt one of the toughest sporting contests in the world. I would say only eclipsed by the Tour de France or a two week tennis grand slam decided by a five set marathon.

Since moving to Melbourne five years ago, I’ve become a big fan of the AFL. It’s a great game, and a more engaging contest on a week to week basis. But it has nothing on Origin.

I’m partial, though. I grew up in Wollongong playing rugby league from the age of seven. I ended my career at 20 playing at Leichardt oval in Sydney’s inner west, with a busted knee that needed three operations to fix.

A few months later, the Super League war broke out and my teammates were getting handed cheques for $50,000 to sign to one side or the other. Meanwhile, I watched from the grandstands with a pin in my knee and a brace around my leg.

Before that, I picked up a dodgy ankle, shoulder, and lower back.

Yes, rugby league really is for idiots.

But played at its peak, like you’ll see tonight, it is the greatest game of all.

NSW have been the better side this series. If they play with the same intent for 80 minutes tonight, they will win.

Go the Blues!

Now, with that shameless plug out of the way, and hoping I haven’t upset my Queensland friends too much (Vern Gowdie, also published today in Money Morning, being one of them), let’s get on with the story…

Should we continue our conversation of the last few days? I think so…

The interest rate cycle

If you remember, we were trying to work out when the Federal Reserve’s interest rate raising cycle will hit the stock market and the economy.

As I said yesterday, it’s not really a question of if this will happen, it’s a matter of when. Interest rate rises by the Fed preceded every post war recession. They continually misjudged what the ‘natural rate of interest’ was.

This is like the equilibrium rate across the economy. Given that no one knows what this rate actually is, you can bet that they’ll stuff it up again.

After writing on this topic for a few days already, I thought I should look up the Federal Reserve website and see what the esteemed members of the Fed’s Board had to say about their plans for raising rates.

Funnily enough, Fed Governor, Jerome Powell had a bit to say on the topic of the ‘neutral rate’ (the same as the natural rate) in a speech he gave at the Economic Club of New York on 1 June. It gives us a few clues as to when the Fed might cause the next US recession. Here’s an excerpt (my emphasis added):

In the case of the federal funds rate, the endpoint of that process will occur when our target reaches the long-run neutral rate of interest. Estimates of that rate are subject to significant uncertainty. The median estimate of its level by FOMC participants in March was 3 percent, more than a full percentage point below pre-crisis estimates. This decline in the long-run neutral rate, and an even larger decline in the short-run neutral rate, imply that even the very low rates of recent years may be providing less support to the economy than may appear. At present, the median FOMC participant estimates that we will reach a long-run neutral level by year-end 2019 if the economy performs about as expected.

The Fed thinks the neutral rate of interest (or the natural rate as I have referred to it over the past few days) is around 3%. That means they plan to keep hiking rates to that level by December 2019.

The chart below accompanied Powell’s speech. The red dots represent the Fed’s interest rate forecasts made in March. The plan — at this stage at least — is to be at 2% by December 2018 and 3% by December 2019.

The federal funds rate currently sits at 1.25%. That means we’ll see another three rate rises over the next 18 months. That seems do-able. Whether the US economy can then handle another four rate rises in 2019 remains to be seen.

It all depends on whether the Fed is right in their estimates of the natural rate of interest. I have my doubts. I’ll get back to why in a moment.

The federal fund rates 1960-2017

[Click to enlarge]

Here’s what Powell had to say about shrinking the balance sheet (reversing QE).

  • Normalization of the balance sheet will commence only after the normalization of the level of the federal funds rate is well under way.10Most FOMC participants think that this condition will be satisfied later this year if the economy continues broadly on its current path.
  • The balance sheet will be allowed to shrink passively as our holdings of Treasury and agency securities mature (or prepay) and roll off.
  • The process will be gradual and predictable.

It sounds like the Fed isn’t too worried about the impact of shrinking the balance sheet. Nor should they be. Not in the early stages anyway.

That’s because balance sheet normalisation slowly withdraws cash out of the financial system. (The Fed sells mortgage and treasury bonds, for example, back into the market, and takes cash back out in return).

If the psychology of recovery improves as interest rates rise, there will be less need for cash in the financial system, so there shouldn’t be too much of an issue.

But as the Fed continues to raise rates into 2019, investor psychology may change. The market may be concerned about the Fed overdoing it. Investors may seek the safely of cash as they feel the economy moving towards recession.

But by then, the Fed will have removed a lot of the excess cash from the financial system. That means asset prices will be more susceptible to a growth slowdown or recession than they would in the current scenario.

Why?

Well, when there is a significant stock of cash, everyone who wants it can get it, without having to dump assets in a panic. When cash is plentiful, it’s relatively cheap. When cash is scarce (as it always is in a panic or a crisis) it’s expensive.

Another way of saying this is that when cash is cheap, stocks are expensive, and when cash is expensive, stocks are cheap.

Based on this analysis, cash will remain cheap for some time yet. But you may want to start building up a few reserves in 2019 as the Fed overshoots on interest rates once again.

It also means that we’re a few years away from hard times for the market. Sure, we’ll have some scary corrections in the meantime. But overall I think it’s better to be in stocks than in cash right now.

Based on current Fed forecasts for interest rate rises, that view’s not going to change for around 18 months.

As Ray Dalio said, you have to keep dancing…

Regards,
Greg


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing. He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’. That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors. And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis. Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


Leave a Reply

Your email address will not be published. Required fields are marked *

Money Morning Australia