Rate Hike? Not a Chance

Investors have been in a tizzy about whether Janet Yellen & Co. will hike interest rates later today. It’s kind of funny, as if a quarter-point hike will really make much of a difference. Of course, it won’t.

But it’s change, a new data point to contend with. And one thing the stock market definitely doesn’t like is change and the uncertainty that comes with it. 

Investors are hooked on low rates, like a kid on a sugar high. And you know how that goes. Once the sugar wears off, the poor kid starts to get a little grumpy. It’s the same way for investors, except the positive effects of low interest rates wore off a long time ago…

Interest rates alone cannot fuel a robust economic expansion. That’s just not how it works. Sure, when money gets cheaper, it stands to reason that people will borrow more and buy more stuff. And you might even expect that companies to invest more in their production in order to make more stuff for people to buy. That’s where the Fed under Ben Bernanke made a big mistake.

After the financial crisis, Americans had a pretty serious debt problem. It was a hangover from the housing bubble, which was also helped along by low interest rates. Our houses lost value, our investments were creamed, and we lost our jobs. Of course, we still had mortgages to pay and car payments to make. Plus, we were terrified that the economy wouldn’t recover, and people tend to stop borrowing and spending when the future is uncertain.

The point is, no amount of cheap money was going to get people to spend when they had so much debt and fear. In other words, we had a demand problem.

I will still say that Ben Bernanke did the right thing by cutting interest rates to zero. The economy definitely needed a goose, and low rates can help people restructure their debt to make it easier to service. But interest rates should have never been left at zero for so long. Zero rates were an emergency measure, and once the emergency was over, he should have raised them off the floor.

Interest Rate Bubbles  

It’s always tough to know exactly what will happen when you take extreme measures like zero interest rates. But in a general sense, you know that money will be borrowed and invested. Bernanke loved to say he was watching for “dislocations in the economy” as a result of cheap money. He didn’t see them, but they were there…

For starters, we had an oil and natural gas bubble. Oil exploration companies were able to borrow a lot of money to fund their operations. The U.S. went from producing around 7 million barrels of oil a day to 10 million a day in just a couple of years. 

The Saudis popped that bubble a couple years ago by boosting their own production and crushing oil prices. Now we’ve lost over 100,000 jobs in the oil and oil support industries. Over 60 companies have gone bankrupt. Turns out all that borrowed money was invested poorly. That’s what happens when an interest rate-fueled bubble pops.

We’ve also seen a record amount of corporate borrowing to buy back their own stock. Companies have been buying about $1 trillion of their own stock a year for the past five years. That’s not bad in and of itself. Companies buy back stock all the time. However, using debt to do it might sound like a good idea now, but when the next recession hits, companies will still have to make those debt payments. 

Again, you never know where bubbles will form if you leave interest rates low. But you know they’re going to form. That’s why you have to normalize rates as soon as you can.

Stock Market Bubble?

Some people say the stock market itself is in a bubble due to low rates. While I don’t exactly think that’s true, there’s no doubt at all that zero interest rates have pushed stock valuations higher. Just look at how people react every time the Fed says it wants to hike rates: they sell stocks as fast as they can.

If the Fed hiked rates by 50 basis points later today, I guarantee you the Dow would drop at least 1,000 points. And not because a 50 bps hike would grind the economy to a halt. It would happen just because investors are way too comfortable with zero rates. 

It’s to the point now where we’re playing a game of chicken with the Fed. We all know Yellen wants to get rates off the floor. But investors are betting that global economic weakness will prevent her from acting. In other words, the market itself is challenging the Fed. Stock prices keep rising, as investors bet that she will blink first.

That just doesn’t seem like a good idea to me. Why bank on something you know will have to end? And what’s more, you know it probably won’t end well?

At some point, Yellen is going to call the market’s bluff.

The Case for Higher Rates 

I’ve seen some macro-strategist types suggest that these record-low interest rates are actually hindering the economy. The theory goes that banks would lend more if rates were a bit higher. You see, banks make much of their money from spreads, the difference between what they lend money for and what they have to pay on their deposits. They also make money by keeping the bulk of the money that is on deposit in shorter-term Treasury bonds. 

Obviously, banks don’t pay much on the deposits people keep with them. Whatever they can make from lending and from owning Treasuries is gravy. 

But right now, the 10-year Treasury bond is yielding about 1.6%. In other words, virtually nothing. So that leaves lending.

As of yesterday, the average 30-year mortgage rate was about 3.7%. Yep, banks aren’t making very much off loans. And that may well be keeping them from lending as much as they might. (Now, I know nobody feels bad for the banks. And you shouldn’t. They helped get us into this mess in the first place.)

Yellen is almost certainly not going to hike interest rates today. But maybe she should. Rates need to come off the floor. The sooner the better.  

Until next time,

Until next time,

Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.