The Federal Reserve gave a very telling speech on March 28th. In this speech, what I've been concerned about for several months was confirmed. That is, as interest rates increase, unemployment will increase in tandem. As unemployment increases, the overall stock market will fall.
In the speech given, Janet Yellen essentially spelled out a cautious stance for monetary policy in the short-term. Basically, we've seen the market responding with one of the first major pauses and pullbacks since the Fed's aggressive actions following the financial crisis. As Yellen has increased the interest rate, we've seen the dollar start to collapse as investors remove capital from the U.S. economy and shift it to arenas offering higher rates.
Here's why Yellen is worried and taking a cautious stance. When the Federal Reserve increases interest rates, nearly everything in the economy immediately begins to slow down. The discount rate which the Federal Reserve manipulates is one of the key rates for the entire economy. Nearly every other rate evaluated by nearly every individual trades or fluctuates as a differential to this interest rate. In essence, the discount rate is a risk-free rate of a return - a return by which all other returns are evaluated. When the discount rate is increased (as it was this past December), all other interest rates tend to increase as well. This has huge ramifications for businesses.
A typical business only pursues opportunities if it offers an attractive return versus alternatives. When the discount rate increases, the quantity of projects evaluated and pursued decreases since the risk-free rate of return becomes more attractive to investors than riskier alternatives. This depresses employment. When firms pursue fewer projects and investments, fewer workers are hired, wages tend to stall, and the economy flounders. And this is exactly Yellen's concern. Despite this concern, the Fed has already started the new cycle by increasing rates, setting in motion the standard Fed cycle of tightening followed by panicked easing.
You see, we're already in a bit of a pickle. In case you missed it, manufacturing recently hit the lowest level we've seen in 7 years.
The ISM Manufacturing Index is constructed by polling manufacturing firms to create a comprehensive figure which represents the health of the industry. When the number falls, the industry is in decline. The number 50 is considered to be a "magic" number by some in that when the index is below this threshold, recessions tend to ensue. We've been under this threshold for the longest stretch since the financial crisis. The economy has been slowing. If the discount rate continues to rise, the economy will more than likely continue to slow.
Pay very close attention to the Federal Reserve in the coming months. If the Federal Reserve aggressively pushes through more rate increases, the economy will contract and unemployment will rise. There really aren't very many ways around this. The reason this is relevant to investors is that there is a direct and powerful relationship between unemployment and market returns. When unemployment rises, market returns fall. As it is, the Fed has already started to act, which is why I suggest a preemptive short against S&P 500 futures (NYSEARCA:SPY). I will continue this bias until the S&P 500 exceeds its all-time highs by 5% for at least a week. Until then, short it is!
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.