“The FOMC decided today to keep its target range for the federal funds rate at 0 to 0.25 percent.”
Since the December 2008 Federal Open Market Committee (FOMC) meeting, the above-described policy guidance has been a mainstay in every subsequent statement. That’s 56 meetings in a row for those of you who may not be keeping score.
What does it mean when committee members explain that the Federal Reserve will “keep its target range for the federal funds rate at 0 to 0.25 percent?” In essence, the Fed is simply setting the rate at which the biggest and most creditworthy banks may lend to one another.
Isn’t this a bit like borrowing money for nothing? You bet! Think of the banking system as a giant pyramid of credit, with the Federal Reserve sitting at the top. By setting the rate at which the largest banks lend to one another, the Fed creates a ripple effect in borrowing that resonates throughout the pyramid. Consumers like you and I sit at the very bottom of that pyramid.
It follows that for 56 meetings, over six-plus years, borrowers have had it pretty easy. And who has been borrowing? Corporations have borrowed “on the cheap” to buy back stock, increasing demand for a dwindling supply of shares and pushing prices to all-time record highs. Consumers have borrowed cheaply to finance and refinance mortgages as well as to maintain standards of living that are not being maintained by inflation-adjusted declines in wages.
Disturbingly, the Fed has expressed a desire to raise bank-to-bank lending rates in 2015. When they do raise the target, it will effectively tighten the lending gears, potentially crippling the demand to borrow and making it less affordable for businesses and corporations to take on new debt. It also makes it more challenging to service the old debt, as higher rates will need to be paid on the old debt’s interest.
From the debtor’s (borrower’s) perspective, ultra-low rates are viewed as positive. We get to buy more houses, cars, LED televisions, iPads, stocks (on margin) – we can acquire more stuff than we otherwise would not be able to afford if the borrowing costs were much higher. Indeed, consumption patterns of borrowing-n-buying and the effect that those patterns have on the overall economy can be traced back to Fed policy.
From the creditor’s (lender’s) perspective, however, ultra-low interest rates are dreadful. After all, if you lend your money to a company for five years, shouldn’t you be paid a reasonable amount of interest for the risk that you are taking? Unfortunately, in today’s world, you’d be lucky to get 1.5%-1.75%, or less than the overall rate of inflation. Without a doubt, when the Fed favor’s borrowers – to this extent and to this length of time – conservative investors and savers suffer. The CDs and investment-grade debt that used to yield a comfortable 3%-6% disappears, and similar returns can only be pursued in far riskier junk bonds.
From “Risk-Free” To “Free Risk”
Risk-free CDs would have paid you 4-5% eight years ago. CDs and investment grade bonds could have been laddered to provide many retirees predictable and reliable cash flow in retirement. When was the last time that you witnessed a bank offering a 5% CD? Where do you go today to get that kind of return?
Unfortunately, everyday folks have been forced by the U.S. Federal Reserve to invest in far riskier assets than ever before. Higher-yielding junk bonds. Dividend paying stocks. Heck, a 2% dividend yield may not even cut it, so many have resigned themselves to investing in the broader U.S. stock market to maintain a standard of living. Hence, demand for stocks goes up and, just as Economics 101 teaches us, so too do the prices of stocks.
Not surprisingly, the current bull market in stocks entered its seventh year this past March. Throughout the years, the Federal Reserve combined zero percent interest rate policy with emergency measures (i.e., quantitative easing) to further decrease longer-term borrowing costs. Six months ago, however, the emergency stimulus of quantitative easing (QE) ended. What’s more, the Fed is mulling over how and when to raise rates here in 2015.
Does that mean the tide in stocks could shift because the Fed is expected to raise rates? Perhaps. But you shouldn’t hold your breath. The rising interest rate story has been so popular for so long, it begins to sound more like a fairy tale. The truth is, if the Federal Reserve pushes up its overnight target lending rate, it would likely cause borrowing costs to rise for highly indebted states (e.g., Illinois, California, etc.) and highly indebted countries (e.g., Brazil, Italy, Spain, etc.). Those would be interest payment hikes that those states and countries would struggle to afford.
Okay, but with rates already this low, how on earth could they move any lower? Well, the world now has “negative interest rates.” That’s right… negative interest rates! Crazy as it sounds, there are several European central banks that have cut rates well below zero, including Switzerland, Sweden and Denmark. It is a bid to lower the value of respective currencies to remain competitive as well as a desperate attempt to punish banks and bank depositors that are hoarding cash. After all, an economy cannot grow unless consumers are spending.
Now I’m not saying that we will ever reach that same level of desperation that we are seeing in Europe. On the other hand, interest rates have been moving lower for 34 years – nearly three-and-a-half decades – and there’s very little reason to expect the trend to change now. Not only do the credit spreads between U.S. sovereign debt and foreign sovereign debt need to contract, but the U.S. government and U.S. households may not be capable of handling anything but incredibly low interest rates.
So, where will the Fed take rates by the end of this year? Although it’s difficult to say, there is some writing on the wall. In December of 2014, the Fed officials’ median estimate on the federal funds rate at the end of 2015 was 1.125%. In other words, Fed officials were expecting to raise the overnight lending rate by a quarter of a point (0.25%) in four or five out of the eight FOMC meetings scheduled in 2015. Reality quickly altered that view, however. It took only three months’ worth of weak economic data for those same Fed officials to slash their median estimate from 1.125% to 0.625%.
So with two FOMC meetings already in the books without a rate hike, Fed officials are now expecting only two rate hikes by year’s end. Can you begin to see how certain addictions are nearly impossible to break?
How Long Can The Bull Market Carry On?
With that said, the idea that ultra-low rate policy can forever push riskier assets like higher-yielding bonds and stocks higher is misguided. Granted, the Fed’s monetary policy has been the single most important factor in driving the prices of stocks, bonds and real estate upward. Yet ultra-low borrowing costs is only a means to an end, not the “end-all-and-be-all.” What is the “end-all-and-be-all” in the world of successful investing? CONFIDENCE.
Confidence allows stocks to hang out at historically high valuations in spite of weak corporate earnings, negligible wage growth and decelerating gross domestic product (GDP). To put it another way… if I told you that we would need to keep the overnight lending rate at 0% for another six years, plus inject another $3 trillion in electronic dollar stimulus to keep the economy afloat, would you have the same confidence as you have developed over the previous six years?
The S&P 500 has climbed more than 200% already. Clearly, stock investors have been supremely confident that the Fed can and will do whatever it takes to keep recessionary pressures at bay. Every previous round of QE has been proof of that fact. Nevertheless, there will come a day when the Fed will misstep (e.g., move to slowly, move to quickly, move too far, not move enough, etc.) where confidence in the smartest people in the world begins to wane.
Gary and I frequently discuss the options that we think the Fed has with regard to monetary policy. Whether they take interest rates higher, keep them low, or inject another round of QE, investor confidence can keep the bull market alive. Sooner or later, though, the Fed will appear out of touch and/or look desperate; sooner or later, a serious policy misstep is likely to tilt the pinball machine.
Think the Fed’s powers of persuasion are unstoppable? Think again. Many recall how the Greenspan-led Fed raised rates too erratically and too quickly leading up to the 2000 dot-com disaster. Others should remember that the Fed raised rates 17 times in an orderly fashion, too slowly to curb housing speculation. And when it was clear to nearly everyone that the economy was in a serious slump, the Fed had been way behind the curve by not lowering rates sooner and quickly enough; the 2008 financial collapse decimated trillions in wealth.
This is not to say that bad things would not have happened had the Fed played their cards perfectly. On the contrary, bad things would have happened for one reason or another, to one degree or another. The take-home here is the reality that the Fed is not infallible, nor is confidence in the central bank a permanent state in the collective conscience of investors.
Let’s keep in mind, the S&P 500 has been struggling to eclipse the highs set on March 2. If that does not change quickly, the bull may be heading out to pasture sooner than many are anticipating.
Am I predicting the end of the second longest bull market in over a century? Hardly. As an investor and money manager, I need to consider the ramifications of risky behavior shifting toward risk aversion. It may be time for you to consider those ramifications as well.
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