Why The Fed Won't Raise Rates (Ever)

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Summary

There is still slack in the economy as measured by work force participation.

Our trading competitors are at negative rates.

Is anyone looking at the interest on the National Debt.

What will this do to currency flows?

In the story "The Boy Who Cried Wolf", the moral of the story is that if you lie to people once too many times, then they won't believe you when you are telling the truth and need their help. That seems to be the Federal Reserve's only real reason to really, really (no, we really mean it this time), raise rates in November or December.

Let's start with a bit of history. The last time the Fed raised rates, in December of 2015, they told us that they would probably raise rates three or four more times in 2016. Throughout the year, each time the Fed has met, we have been told, "Good night Wesley, I'll most likely kill you in the morning." Actually that's the Dread Pirate Roberts from The Princess Bride, but they have told us essentially the same thing, "We didn't raise rates this time, but we probably will at our next meeting."

So now, in the just released Fed meeting minutes, the primary reason to raise rates at the upcoming meeting seems to be, "In order for us to maintain credibility, we need to raise rates." Notice that isn't a macroeconomic reason, it isn't a microeconomic reason, it isn't even a good reason, it is simply the Boy Who Cried Wolf reason. "If we lie to the market one more time, we'll be seen as the boy who cried wolf", they seem to be saying. While that may be true, it isn't a reason to slow what is by the best of measures a tepid recovery.

So here are my four reasons that the Fed won't (or at least shouldn't, raise rates at the next meeting, or anytime in the next year or two).

Number one - Work force participation is still at a multi-decadal low.

Click to enlarge

The labor force participation rate is currently about 63%. No case can or has been made by the Fed that this constitutes "full employment" or that we are at a rate of employment which may imminently cause inflation. In fact, if full employment is close to what we experienced in 2000 (Though the bogeyman that the Alan Greenspan Fed used at that point about labor caused inflation never materialized) then the employment rate could increase from (approximately) 63% to 67%. This 4% swing represents again approximately 9 Million jobs that could be created without causing inflation. At the rate we are currently adding jobs (about 200,000/mo) we could go for forty two months without seeing significant inflation, that's without accounting for population growth.

Number two - Our trading competitors (China, EU, Japan) are at low rates and in the case of EU and Japan they are at negative rates. If the Fed raises rates, the value of the dollar will (and already has in anticipation) go up in value and our trading competitors currencies will go down in value. This will damage our ability to export (Caterpillar (NYSE:CAT), Boeing (NYSE:BA) etc.) which will cost domestic jobs while at the same time bolstering our competitors ability to export to us. This would have the net effect of dampening the U.S economy at a time when the Atlanta Fed says GDP is already shrinking.

Evolution of Atlanta Fed GDPNow real GDP forecast

If the Fed typically raises rates in order to slow an overheating economy, why would it raise rates when it's own measurements indicate GDP is already shrinking, do they want to accelerate the shrink?

Number three - Is anyone looking at the interest on the national debt, or what that interest rate would grow to in an environment of increasing rates. According to US Debt Clock.org we currently pay $248 Billion in interest on $19.6 Trillion in debt (about 1.26%). What would that number become if interest rates went up 0.25% for three or four increases during the course of 2017. What would the interest rate on $20 Trillion become? 2.25% of $20 Trillion is $450 Billion. You read that right, the service on the debt would almost double and the Federal deficit would grow by $202 Billion per year. Does anyone think the Federal government can afford to go back to deficits approaching $800 Billion per year? Some might say, "That's true but profits made by the Fed are repatriated back to the Treasury". Problem is, the Fed doesn't hold all US Government debt, a great deal is held by foreign governments. So an increasing share of the Federal budget would be going to fund other governments, not our own, in the form of interest payments.

Number four - as mentioned in Number two, increasing interest rates in the U.S. will cause the dollar to increase in value vs other currencies, this will make it harder for US companies to export. Another consideration is the idea that a stable currency and increasing interest rates will cause foreign investors, particularly those facing negative interest rates at home to seek investments in the U.S. The Federal Reserve, increasing interest rates will have exactly the opposite of their desired stated goal. Namely it will destroy export-based jobs and create a Forex driven bubble in U.S. equities and other investments.

The Fed has two mandates, to limit rate of inflation to approximately 4% and to maintain an unemployment rate of approximately 4%. Currently inflation is measured at somewhat over 1% depending on what measure you use. AND, as already stated in Number one above, Labor Force Participation is at a multi-decade low, no where near an inflation causing rate. With everything to lose and nothing to gain by increasing rates, the Fed's only reason to increase rates is, "We'll lose credibility if we don't". Which is probably why they will.

If they do, what investment thesis goes along with these macro-economic impacts? If you believe that the Fed will increase rates in November or December you should consider the following strategies:

  1. Go long the U.S. Dollar and short everything denominated or purchased in dollars. Gold will go down in value, oil will go down in value etc. Companies that get a significant amount of revenue from exporting will go down in value. A bit more detail on oil going down in value is warranted here. It has been true during 2015 and 2016 that as the price of oil changed a similar change in the market was observed (correlation). Strangely, this is true even for companies that absorb a significant amount of oil cost in their cost of doing business United Parcel Service (NYSE:UPS) and Federal Express (NYSE:FDX) for example. It is worth looking at whether to short the whole market or to go long volatility (VIX). At the same time if oil is cheaper for longer, I believe it could go back to $35/bbl, then eventually companies like UPS and FedEx should be able to show improved operating margins.
  2. If you are investing overseas look for companies that make a significant amount of their revenue by exporting to the U.S. for instance Nestle (NESN).
  3. Consider taking a European or Japanese vacation, because when converted to dollars everything in those countries will be on sale.

On the other hand, it is possible that the Fed is simply crying, "wolf" one more time and that they will not raise rates. If they are in fact, data driven, there is no reason on earth to raise rates.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.