Fed Meeting On 30 January 2018: Impact On Investment Markets

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

Summary

The FOMC meets in five days time and are likely to raise rates again.

A 0.25% interest rate increase sends on average of $70B per annum to private commercial bank interest income. The banking sector will profit by at least this much.

A higher interbank rate will also increase the interest payment by the government on Treasuries and will add $51B per annum to the economy.

Raising rates will create its own cost-push inflation similar to a rise in the price of oil.

This article will show why the Fed has no reason to raise rates at this next meeting cycle and indeed any foreseeable meeting. Also, the impact of an interest rate rise will be assessed together with a look at how this impacts investment markets.

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

Many key indicators are pointing to a decelerating credit market where an increase in the price of lending would not increase demand for loans or the real goods and services that these loans are used to purchase.

The chart below shows commercial and industrial loans creation is now barely positive at just over 1%, down from over 8% in September 2016. A clear collapse in credit growth.

The chart below shows the demand for consumer loans is falling. The rate of growth has halved since August 2016.

The chart below shows the growth rate for auto loans is falling. In less than a year it has more than halved.

Final sales of autos have been flat since the first quarter of 2015 as the chart below shows. Loans create deposits, generate reserves at the Fed, add to demand and fund sales.

The chart below shows that the growth rate for real estate loans is falling.

Existing home sales have flat-lined and been the same for over two quarters as the chart below shows.

The last two times that private credit creation rolled over and headed south were significant events as the chart below shows. Recession. The grey areas of the chart below are recessions.

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 on treasuries (which puts more "State Money" in circulation as opposed to bank created "credit money"), so it can all not only keep going but also accelerate.

However, if demand is weak, like now, and rates go up as they did late last year due to an anticipation of Fed hikes, borrowing and spending can decelerate as the charts above show is happening.

Now is not the time for rate hikes.

The FOMC Dual Mandate

The monetary policy goals of the Federal Reserve are to foster economic conditions that achieve both stable prices and maximum sustainable employment.

- (Source: Federal Reserve Bank)

So are there:

1. Stable prices?

2. Maximum employment?

Prices are stable and at or below the FOMC's 2% target as the chart below shows. The trend is now downwards after a peak in September of just over 2%.

Inflation was higher at 2.7% in February 2017 and has declined since.

Employment of land, labor, and capital is not maximized, as the charts below show.

The number of employed persons has peaked and fallen since March 2017, as shown in the chart below.

The number of employed persons is a good measure as it is ascertained by companies reporting how many people work for them and cannot be massaged easily up or down by political spin doctors. One is either working or not. There or not there. The number has been falling since September 2017.

If one were to use the same participation rate as existed before the GFC, the unemployment rate would be double the official rate now as the chart below shows.

(Source: Professor Philip Soos)

Capacity utilization has been falling for decades and is low at just over 77% as the chart below shows.

This means that approximately one-quarter of America's land and plant capacity is offline and standing idle.

America cannot experience real demand-pull inflation until both labor employment and industrial capacity utilization are much higher. Demand in an economy must outrun production before real demand-pull inflation can occur.

Cost-push inflation can be created though; this is where prices increase with no increase in the production of goods and services. This can be achieved through a rise in the price of oil or a rate increase.

The Fed, can in effect, create its cost-push inflation by increasing the price of money.

What Happens if the Fed Does Raise Rates?

Credit growth for 2017 was $23B or 0.1% of GDP. In other words quite weak. The flow of new loans adds to the stock of existing private debt in the economy. The chart below shows the stock of private debt.

(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 loan 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 for 2017 was $18,624.48B. 150% of that is $27,937B. This is 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 tradingeconomics.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 $70B or 0.38% of GDP is funneled off to private commercial banks as debt service. Note that no other products or services have been created or demanded but that the cost of business across the economy has risen by $70B for no gain.

The banking sector's $70B gain is the rest of the economy's loss.

Another impact is on Treasuries. If there is a general rate rise, then the yield on Treasuries will also rise as new Treasuries are issued at the new higher rate and as existing ones trade on secondary markets.

The chart below shows the stock of Treasuries on issue. (Treasuries do not have to be issued at all, and that is covered in this article)

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

(Source: Author calculations based on tradingeconomics.com Government Debt measure)

The government credits the bank accounts of coupon recipients to pay interest on issued Treasuries. The number in the bank account of the recipient increases upon direction from the Treasury. At that point, new money 'State Money' enters the private sector and adds to the money supply.

With each rate rise, some $51B of new money enters the private sector from the government sector. This is the positive side of the equation in that more dollars in the economy grow the economy.

Gross Domestic Product = Gross Domestic Income.

GDP = GDI.

If income rises by $51B, then GDP can rise by at least the same amount.

The chart below shows this relationship.

How can one trade this decision?

If the Fed does raise rates in January 2018 as it has signaled and many market pundits believe, then the sector most likely to profit are the large banks as they get a $70B PA income increase on top of the one they received in December 2017. An investor can 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

Personally, I prefer KRE as it is representative of domestic U.S. banks who enjoy the full benefit of the rate rise.

Disclosure: I am/we are long KRE.

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.