Guest Post: 3 Myth’s About Rising Interest Rates

During my morning reading, I ran across an article by Howard Gold entitled “Why Diversification Isn’t Working?” by Howard Gold wherein he discusses that investors are faced with having to choose between many bad choices.  He stated:

“That’s the problem many investors face now. Risky assets, like stocks, commodities, and real estate are moving in lockstep. Only long-dated bonds are swimming against the tide, and nobody wants them because of fears the Federal Reserve will eventually stop its massive bond buying and raise interest rates.

 

So, the choice appears to be throwing even more money into stocks, which are nearly five years into a bull market, or buying bonds, which we know will go down in price. Or keeping more in cash (with its negative real return) or stuffing money in the mattress. Or, God forbid, buying leveraged inverse ETFs as a ‘hedge.’ (emphasis added)”

The analysis by Howard Gold has become a mainstream staple within the financial markets that when the Federal Reserve “tapers,” or eventually ceases, its current bond buying program that interest rates will begin to rise.  However, there are three primary issues which should be considered that fail to support this widely held belief.

Interest Rates Will Rise

The first misconception is that when the Fed tapers its ongoing liquidity program; interest rates will begin to rise.  However, there is no anecdotal evidence that would be the case as shown in the chart below.

In fact, the recent rise in interest rates should have been anticipated as that has been the case during both previous programs.   It was not until the programs began to “taper,” and eventually end, that rates fell as money flowed out of risk assets in search of safety in the bond bond market.  This fall in rates also corresponded to economic weakness and expectations of an increase in deflationary pressures.

When the Fed once again begins to remove its accommodative support from the financial markets it will likely lead to a further decline in interest rates as “safety” is once again sought over “risk.”

The Economy Will Be Recovering Which Will Push Rates Higher

The second misconception is that the Fed will begin to taper their current bond buying program as the economy strengthens enough to warrant the removal of those accommodative policies.  However, as I discussed in “30% Up Years” the economy is already in the 7th longest expansion since 1879 as shown in the chart below.

The problem for the Federal Reserve has been that each time they have previously withdrawn financial accommodation the economy has flagged pushing interest rates lower.

The question that investors should be asking themselves is how much longer will the current economic expansion last given the lack of underlying drivers that have historically contributed to strong periods of economic growth.  The Federal Reserve’s programs have been effective in pulling forward future consumption to support the current economy.  However, the extraction of those programs will likely reveal a the future “void” that has been created.

The Liquidity Trap

The last reason that interest rates are unlikely to rise is the realization that the Federal Reserve has become unwittingly caught within a liquidity trap.  I discussed this is detail previously in “What Is A Liquidity Trap” wherein I stated:

“For the Federal Reserve they are now caught in the same ‘liquidity trap’ that has been the history of Japan for the last three decades.  With an aging demographic, which will continue to strain the financial system, increasing levels of indebtedness and poor fiscal policy to combat the issues restraining economic growth it is unlikely that continued monetary interventions will do anything other than simply foster the next boom/bust cycle in financial assets.   The chart below shows the 1-year Japanese Government Bond yield as compared to their quarterly economic growth rates.  Low interest rates have failed to spur sustainable economic activity over the last 20 years.”

The problem that the Fed has already witnessed, and something I have discussed several times in the past, is that even small incremental increases in interest rates has an immediate negative effect on interest rate sensitive economic activities like business lending and real estate.

The Federal Reserve has gotten itself trapped into creating an asset bubble in the equity markets because any reversal of policy leads to severely negative economic consequences.  With the current economic recovery cycle already very extended in historical terms, along with the financial markets, it is unlikely that we have just begun a growth cycle that will allow the Federal Reserve to extract its support.  The reality is quite the opposite, and the next asset rotation will not be from bonds to stocks; but just the opposite.