Assessing The Impact Of The Fed Rate Rise And The Prospects For More

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Includes: DFNL, DPST, FAS, FINU, FNCF, FNCL, FTXO, FXO, IAT, IYF, IYG, JHMF, KBE, KBWB, KBWD, KBWP, KBWR, KCE, KRE, PFI, PSCF, QABA, RWW, UYG, VFH, XLF
by: Alan Longbon

Summary

Assessing the impact of the recent and planned Federal funds rate rise and the prospect for more.

Lending rates of all types are falling sharply.

Existing high levels of private debt mean there is little demand for more, and higher interest will drain more aggregate demand into debt service rather than real goods and services.

Raising rates now will lead to cost-push inflation and not demand-pull inflation. By 2020 and additional 3% of GDP will be flowing to the banking sector as interest income on loan assets on issue.

Wealthy government bondholders pushing the Fed for a pay rise got their pay rise and plan on three more next year.

This article will show the impact of the recent federal funds rate rise on the stock of outstanding private debt. In addition to some recent history and a brief description of how the Fed works. The article concludes with a forecast of future FOMC rate increases and what this means for macro-fiscal flows and investment markets and how an investor might profit from this knowledge.

The Fed, a Brief Overview

The Fed through its intraday interest rate-setting power controls the price of short-term money and hopes that an adjustment at the bottom will ripple up the yield curve. The Fed controls only the intraday rate; the rest of the yield curve is market-determined. Or at least it used to be.

In more recent times since the 2007-2009 GFC, the rest of the yield curve has also come under the control of the Fed. Using open market operations to buy long-dated bonds, the Fed has been managing the long end of the yield curve as well. This has also been going on at other central banks such as in Japan (where the practice began) and the European Central Bank.

The case not to raise

I made the case not to raise in this article before the December 2017 FOMC meeting. Despite my article, the FOMC raised anyway. It was as though they had not read the article.

The main point from the last article was that the demand for credit was falling and that it made no sense to raise the price.

From the chart, one can see that since 2000, once credit creation did roll over, it did not once recover and instead fell into the next recession. The slowdown was in each case the beginning of a "rounding top" and a downward trend that went on for years afterward.

Raising interest rates depends on the situation:

In good times, if rates go up when loan demand is strong, the borrowing continues, the added loan payments flow back to earnings for the lender, and the government pays more interest (which puts more "State Money" in circulation as opposed to bank created "credit money at interest), so it can all not only keep going but also accelerate.

However, if demand is weak, like now, and rates go due to an anticipation of Fed hikes, borrowing and spending can decelerate, as the charts above shows is happening.

With total bank credit just over $12.5 trillion, it's about $500 billion less than it would have been had last year's loan growth continued on track.

If this lower rate of loan growth continues and is not replaced by some other income channel, such as government spending or export income, the implication is that GDP could be a full 2% less than last year. A substantial portion of bank lending finances purchases of real goods and services, and with less aggregate demand from private credit creation, these goods and services will remain unpurchased.

Credit creation in 2016 was quite high averaging over 5% for the year and made a contribution of 0.7% to GDP.

The Stock of Private Debt

For 2017, credit growth story is very different. Credit creation has flat-lined with just as many people paying back their loans as new loans generated. The chart below shows how the stock of total debt is building for both the household and corporate sectors:

(Source: Professor Steve Keen)

The stock of private debt is about 150% of GDP, down from the GFC peak of 170%. One can work out the impact of federal fund rate increases on this stock of debt assuming that it is all at variable interest rates. Some loans are fixed, some will increase by more than the rate rise, some loans interest rates are much higher than the base rate.

The bulk of loans are mortgages and are at a lower rate than say auto or credit card loans.

GDP is currently $18569B. 150% of that is $27853B, this the stock of private debt created by private commercial banks at interest impacted by the FOMC rate rise.

The following table shows the impact of the rate rise on the stock of private debt in absolute terms and as a percentage of GDP.

(Source: Author calculation based on Trading Economics dot com GDP measure)

One can see the fiscal drag placed on households and businesses when each rate rise is passed onto the private sector by the banks when the FOMC raises the interbank rate at its meetings.

Each time the interest rate is raised 0.25% an additional $69B or 0.37% of GDP is funneled off to private commercial banks as debt service. Note that no additional products or services have been created or demanded but that the cost of business across the economy has risen by $69B for no gain.

This is pure cost-push inflation where one receives the same product or service, in this case a loan, and simply pays more for it. The same impact one receives from an increase in the oil price. The cost of living and doing business have increased but nothing new or better has been produced to match the increase in cost.

Future Plans

The FOMC plans to raise three more times in 2018 by which time the additional private interest debt burden will have risen to a further $278B or 1.5% of GDP. The FOMC dot plot below shows how the FOMC members are planning their moves.

In planned steps one can see that the banking sector is set to have up to an additional $278B in annual interest income on loan assets channeled to it by the FOMC rate rises just in 2018. There is much more to come as the FOMC dot plot above shows. The FOMC's curve is going up while we have seen from the charts above that the demand for loans is going down. What will go up is the interest burden on the existing stock of private debt on issue and this goes straight to bank profits.

The Fed has just raised rates thus channeling some $69B of additional income to the banking sector from other areas of the private sector, banking profits must rise from this. The Fed is on record to keep raising rates with three more expected in 2018.

If the FOMC rate rises go as planned to 2020 and rise by an additional 1% then there will be some $557B per year of additional interest income flowing to the banking sector on what there is now, every year. That is over 3% of GDP!

How can one trade this decision?

One may not agree with the system we have built for ourselves where the bulk of the population lives in debt peonage to the financial sector which is then allowed to set its own rates. One could well make out the argument that the economy might run better if credit were issued at cost and the interest burden not allowed to consume so much aggregate demand that the rest of the economy suffers. But that is not the system we have and an investor can a take advantage of this event via a position in the following ETFs:

(XLF)

Financial Select Sector SPDR Fund

(VFH)

Vanguard Financials ETF

(KRE)

SPDR S&P Regional Banking ETF

(KBE)

SPDR S&P Bank ETF

(IYF)

iShares U.S. Financials ETF

(FAS)

Direxion Daily Financial Bull 3X Shares

(IYG)

iShares U.S. Financial Services ETF

(FXO)

First Trust Financials AlphaDEX Fund

(FTXO)

First Trust Nasdaq Bank ETF

(FNCL)

Fidelity MSCI Financials Index ETF

(KBWB)

PowerShares KBW Bank Portfolio

(UYG)

ProShares Ultra Financials

(IAT)

iShares U.S. Regional Banks ETF

(KBWD)

PowerShares KBW High Dividend Yield Financial Portfolio

(QABA)

First Trust NASDAQ ABA Community Bank Index

(PSCF)

PowerShares S&P SmallCap Financials Portfolio

(KBWR)

PowerShares KBW Regional Banking Portfolio

(KCE)

SPDR S&P Capital Markets ETF

(KBWP)

PowerShares KBW Property & Casualty Insurance Portfolio

(DFNL)

Davis Select Financial ETF

(PFI)

PowerShares DWA Financial Momentum Portfolio

(JHMF)

John Hancock Multi-Factor Financials ETF

(RWW)

Oppenheimer Financials Sector Revenue ETF

(FINU)

ProShares UltraPro Financials

(DPST)

Direxion Daily Regional Banks Bull 3X Shares

(FNCF)

iShares Edge MSCI Multifactor Financials ETF

A totally risk-free return, backed by the currency issuing monetary sovereign, can be obtained by buying newly issued treasuries at the new higher rate. This is where the power behind the throne lies. Once one has built a huge stockpile of private wealth one would wish to obtain a risk-free income that allows one to also maintain that stock of extreme wealth. Treasuries perform that role.

One can also enact legislation on Congress that it must match its deficit spending with a bond issue, and then buy that bond issue, and bask in the glory that it looks like you are funding and helping the government. The truth of the matter is that the legislation was never required and has placed an unnecessary voluntary budgeting constraint on government stopping it from pursuing the public purpose while providing bondholders with a risk-free income.

The income from treasuries has in the opinion of ultra-wealthy bondholders been too low for too long and they are pushing for and achieving rate rises and thus income increases via their connections in the press, educational institutions, government, and politics.

On the plus side if the rate of return from treasuries does increase it will put more interest income back into the economy from the currency sovereign. This is the best sort of money creation as it comes directly from the government with no debt attached. State money. Using state money, private debt can be retired thus lowering the stock of private debt at interest from banks.

Government fiscal programmes have the same impact.

The ending and unwinding of Quantitative Easing (QE) will also put interest income back into the private sector. At present, the income from the $4T+ of long-dated bonds held by the Fed flows to the Treasury/Government which as the currency issuer does not need the income. Rather like putting seawater back into the sea.

When QE is unwound and the private sector holds these income generating assets the income will flow to it instead. Normally banks swap their excess cash reserves for long-dated bonds, so as QE is unwound these assets will again sit in the banking system adding to bank income and is another reason for exposure to the financial sector.

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.