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The Risk Of Rising Interest Rates - Causes And Consequences For U.S. Financial Markets

Mar. 02, 2018 11:42 AM ETTFLO, USFR7 Comments
Hedged Equity profile picture
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  • American wages are showing almost no growth.
  • According to the BIS, total dollar-denominated debt outside the U.S. is over $10.7 trillion.
  • The U.S. debt to GDP ratio now stands at an all-time high of 105.4%.

Up until very recently, investors and the general public saw the American economy walking a path of moderate economic growth accompanied by low inflation levels. The crisis of 2008-2009 majorly influenced the Fed to adopt a policy of zero interest rates and monetary expansion in order to avoid a potentially large contraction in GDP. The Fed was successful in containing the aftermath of the financial crisis, allowing the financial system to recover and the stock market to bottom in March 2009. GDP growth, after a brief excursion into negative territory, has remained positive for the last 8 years.

The Fed began reducing its $4 trillion in Treasuries in October 2017. It had acquired most of these securities during quantitative easing, which ended in 2014. Although initially it said it would do so only after the Fed Funds rate had reached 2%, it anticipated this action (the Fed Funds rate is currently at 1.5%). Nevertheless, an increasing number of market observers sustains the hypothesis that U.S. interest rates may have already made a long-term bottom in 2016, from which they are now rising. U.S. 10-year treasury rates are already at 4-year highs:

The Fed expects to increase the Fed Funds rate to 2.1% in 2018, 2.7% in 2019, and 2.9% in 2020. Historically, rising or falling interest rate cycles last for decades. In U.S. economic history, they have lasted between 22 and 37 years. U.S. interest rates are currently close to four-decade lows:

For what reasons would interest rates rise at this point, and what would be the potential effects on American financial markets?

The Case For (And Against) Rising Interest Rates

The case for rising interest rates in the U.S. is based on three main premises:

  • The Trump Administration’ s dollar and taxation policies
  • A stabilising economy
  • A tightening job

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Comments (7)

panzer profile picture
i am amazed there are not more comments; this is a terrific, no bs tell the truth article.
Salmo trutta profile picture
The problem with alternative financing theories, e.g., MMT, is the same problem as the Gurley-Shaw thesis: that there is no difference between money and liquid assets.

Money flows, volume X's velocity, may be either robust or neutral, depending upon the crowbar of inflation. Demand-side inflation, monetary inflation, depends upon the predictable rate-of-change in (1) short-term money flows, M*Vt, relative to that of (2) long-term money flows. Note: The RoC in both elements are mathematical constants.

However, whether an increase in short-term money flows ultimately becomes inflationary depends upon supply-side, or productive factors, i.e., where an increase in flow is matched in the marketplace by a corresponding increase / offset in the stock of new goods and services, P*T.

And if labor productivity is increasing, and the price level is stationary, an increase in wage rates is not only not inflationary, it is absolutely essential to the maintenance of a continuous flow of products to the primary consumer markets. I.e., if wage rate increases do take place in a noninflationary environment, this presupposes productivity increases sufficiently, so that product prices fall by an offsetting amount, thus leaving undisturbed the purchasing power of the dollar.

Only the non-inflationary matching of savings with real-investment outlets (S = I), aka, the Golden Era in U.S. economics, where savings were gov’t. insured, e.g., by the FSLIC, and activated (put back to work, or perpetual income redistribution ) via non-bank conduits, by the thrifts (George Baily’s “It’s a Wonderful Life”), fundamentally accomplishes higher levels of real output and thereby higher standards of living/incomes.

I.e., the utilization of commercial bank credit (even Zoltan Pozsar’s funding facility concepts, see Global Money Notes # 10), to finance real-investment or gov’t deficits does not constitute a utilization of savings, since bank financing is accomplished through the creation of new money.
Salmo trutta profile picture
Gov't deficits are crowding out the private sector (catch 22) as R-gDp has currently accelerated. In the longer-term, interest rates will ultimately rise and stocks will ultimately fall to permanently lower levels (beginning in 2019?).

The twin deficits work against the economy through compound interest rates. The interest component on Federal debt will soon become the largest part of the fiscal deficits, and then this works against us as our trade trading partners are financing our debt (accumulating interest payments).
MonteQuest profile picture
$285 billion out of a $719 billion deficit as of today. $806 billion trade deficit.
Salmo trutta profile picture
Here comes a VAT tax. The problem is that there is a finite limit to tax extraction (where the tax base then becomes eroded). The deficits (entitlements), must be markedly reduced.
Good point MonteQ. Spells more high-end consumption An excellent piece and well substantiated. Great work Hedge Equity
MonteQuest profile picture
"On February 2nd the U.S. Department of Labor released data showing a significant increase in wages in January (+2.9% YOY)."

Yes, but mostly for upper management. BLS stats show that the "production" labor force (which is 80%) saw wages only rise +.3% since Jan 2017.
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