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 in the 1990s) and the European Central Bank.
The case not to raise
The conventional logic behind Fed rate rises is that by lifting the rate, credit creation will be reined in and, therefore, less money added to the money supply in the way of new loans. If there are fewer loans, then less can be bought and sold, and the economy is cooled, and inflation tamed.
This logic made sense in the past, as far back as the 1950s because the credit growth rate was at least 5% and often much higher as the chart above shows.
Credit creation now is barely 2.5%, it makes no sense at all to reign it in. One can see from the chart what a fundamental change the GFC made to the US economy and how there has been a paradigm shift. The old rules no longer apply, new ones are needed. Raising now is akin to how army generals might use the tactics from a previous war to fight a war and get swept from the field.
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 has been flat since July 2017. There is no credit creation boom here that needs reigning in with higher rates.
The chart below shows total consumer credit falling, blipped up for Christmas and resumed its downward movement. Again, no signs of a credit boom that needs to be brought under control with higher rates. It would appear the rate rises so far have done their job.
The chart below shows the growth rate for auto loans is falling. In less than a year, it has more than halved.
Loans finance most big-ticket purchases such as autos and homes. The chart below shows that auto purchases are well down:
The chart below shows total construction spending which has not been this low since 2012.
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 have been since late 2015, borrowing, spending, sales and construction can decelerate as the charts above show is happening.
Now is not the time for rate hikes. The rate hikes so far have done their job even though no job was required. The chart above shows that construction activity peaked out at about the time the rate cycle began.
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:
Prices look stable and at or below "target" to me. One could well argue that the inflation that has occurred between the last meeting and this next one was a combination of the Fed raising interest rates and the price of oil rising.
The chart above shows the tight correlation between inflation and the price of oil. It is unequivocal. If the Fed wants an inflation rate of 2% or more, then the oil price is doing the job for the Fed. Raising Fed rates will make this worse and lowering them will offset the inflationary impact of rising oil prices.
The folly of raising rates in a time of high oil prices was seen in the 1970-80s oil shocks: Cost-push inflation on top of cost-push inflation.
Over the long term, since the 1980s, the GDP growth rate has been falling, there is no mistaking the fall from left to right of the blue line. This is due to the build-up of private debt, covered later below. Despite this falling GDP trend, it is unmistakable that a drop in interest rates is met with a rise in GDP. There is a downward falling symmetry pattern to the chart above.
Given that the Fed funds rate was zero not long ago, it means that with the given level of private debt, we have reached the maximum GDP growth rate possible (2.5% to 3%). It, therefore, follows that any rate rise now takes away from this and moves growth downwards.
Going back to the core inflation level once again, if one removes accommodation, they are even more stable and below target as the chart below shows:
It is important to remove shelter from the calculation because this removes the impact of asset price inflation caused by inequality (rich people pushing up rents by bidding up real estate prices to invest their savings). The bulk of the population and those that rent do not enjoy the higher land values but feel them as higher rents.
Employment of land, labor, and capital is not maximized, as the charts below show.
The chart below shows that the employment growth rate is in decline and has been since 2015 when the Fed first started raising rates again. Higher rates will lead to this growth rate declining more. Lower rates will allow it to rise.
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 rate of growth continues to fall, and so the present Fed rate level is doing its job if lower and slower employment is the goal.
The participation rate appears to have bottomed and has been stable since 2016. It is not rising though.
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)
Wage growth is by no means breaking out as the chart below shows.
The years of 4% plus growth are more than ten years behind us.
Even if there were wage growth, it would not be inflationary as the chart below shows:
The chart above shows no link between inflation and wages growth. The relationship looks inverse. This would appear counter-intuitive as a mainstream belief is that higher wages are inflationary and bad, greedy labor, etc. Everybody knows that! Well, it is no longer true, if it ever were.
What happens is that the worker receives a small wage rise, lower than inflation and steadily falls behind. If the worker receives a wage rise higher than inflation, he is more likely to pay down debt than spend the money on consumption. This goes back to the key theme after the GFC of high private debt repayment, this removes dollars from the economy and is deflationary.
Loans create deposits and generate reserves at the Fed, the money supply and aggregate demand and GDP rises. When this process runs in reverse dollars are destroyed, and aggregate demand falls, as does GDP.
Perhaps when private debt is at 30% of 40% of GDP, as it was in the 1950s and 1970s, will the old rules once more apply.
Capacity utilization has been falling for decades and is low at just over 78% as the chart below shows. It is ticking up which is good to see. The long-term trend downwards is unmistakable though.
This means that approximately 20% 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. Even then imports can make up the difference while new capacity is built domestically.
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 Fed rate increase.
The Fed, can in effect, create its cost-push inflation by increasing the price of money which generally speaking increases the price of everything.
The Fed is the currency monopolist and it sets the price, and if it wants rates to rise, it needs to only lift the rate.
What Happens if the Fed Does Raise Rates?
Credit growth for 2017 was $23B or 0.1% of GDP. In other words, quite weak, as shown in the charts above. 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. This is the millstone that is hanging around the economy's neck and the reason the recovery since the recession bottom in 2009 has been so slow compared to other recessions.
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, and 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. It is an intersectoral flow. The pie is the same size, but one slice just got bigger.
Most bank credit is issued for real estate mortgages, and the going rate at present is 4%. This means that over $1.1 trillion or over 6% of GDP is spent on debt service rather than real goods and services. This figure is likely to be conservative given that auto and consumer loans are at a higher rate than real estate mortgages. Not to mention exploding rate mortgage loans (ARMs) adjusting rate mortgages where higher than actual interest rate movements are written into the mortgage contract. When these are triggered, the rate can explode two to three percent on an official rise of only 0.25%. ARMs make up about half of all mortgages and were particularly destructive in the GFC.
Professor Michael Hudson calls this "debt deflation" in the sense that the real economy is deflated by the weight of debt service on outstanding loans. Banks, on the other hand, take the new income as profit and earnings and can expand their capital base and so, in theory, make more loans if there are creditworthy borrowers that want a loan.
Bank profits are then expressed as rising share capital values and dividends and lavish top executive pay and bonuses. Money is harvested from the broad population via loans and funneled to bank shareholder and owner profits in a bottom-up recycling process. This is the trickle-down theory working in reverse.
Loans create deposits and generate matching reserves at the Fed. At present banks pay 1.75% interest on the reserves they borrow from the Fed when they make a loan, this is the rate the Fed sets at its meetings and is shown in the chart below.
Most loans are home loans at about 4% interest which means the banks make an arbitrage profit of over 1.5-2.5%; it can be more if they were not forced to borrow their reserves from the Fed discount window and sourced them more cheaply elsewhere. The profit margin on auto loans and credit cards is much larger, but the market for these is also much smaller.
One would be well advised to take a fixed rate mortgage and to stay clear of adjustable rate mortgages in the present environment.
Another impact of a rate rise 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).
Remember this is private sector money sitting in Federal government savings accounts called Treasuries. It can be repaid in a keystroke by moving the funds from the customer's treasury account to their reserve account in the same way that you might move your money from your savings account to your checking account at your bank. The money is effectively impounded at the safest place on Earth for electronic bank entries to exist, but only at a low rate of interest.
The Fed is after all a bank and Treasuries are its customer deposits.
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 $53B 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 $53B, then GDP can rise by at least the same amount.
The chart below shows this relationship:
The only downside is that this is rentier, unearned income not attached to an increase in production and so has inflation potential.
The actual increase is not as high as shown in the table above as the Treasuries on issue are not all at the new higher rate. They are laddered, and because rates have been lower since 2010, the interest overall is lower. For many years some people bought Treasuries yielding a tiny 0.25%.
This also helps the banks. As part of the Fed's monetary operations, it is required to swap bank reserves for Treasury deposits until it hits its target rate of 1.75%. If the new rate is 2%, it will swap bank reserves for Treasuries at the new higher rate, and the income stream from the Treasuries flows to the banks and is higher than interest on reserves of 0.25%.
How can one trade this decision?
No sensible person would raise rates in the present environment or propose doing so based on the facts set out above. Rational people do not run the Fed; it is a bank run by bankers from the private Wall Street banking profession. These bankers know that each rate rise adds over $70B of income flow to the banking sector. They have successfully engendered an environment where rate rises are both expected and celebrated as it must mean the economy is stronger.
A rate rise does indeed mean more dollars are added to the economy in the form of Treasury interest, and this does grow the economy as it adds to income flows. But this is overwhelmed by the private debt deflationary effect on Main Street.
A rate rise will boost the banking sector at the expense of the rest of the economy, apart from new Treasury deposit holders who will get a pay rise. Banks swap their excess reserves for Treasuries as part of Fed liquidity operations and so will now earn more on these too.
If the Fed does raise rates in June 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 per annum income increase on top of the one they received in previous months. An investor can take advantage of this event via a position in the following financial sector ETFs:
Financial Select Sector SPDR Fund
Vanguard Financials ETF
SPDR S&P Regional Banking ETF
SPDR S&P Bank ETF
iShares U.S. Financials ETF
Direxion Daily Financial Bull 3X Shares
iShares U.S. Financial Services ETF
First Trust Financials AlphaDEX Fund
First Trust Nasdaq Bank ETF
Fidelity MSCI Financials Index ETF
PowerShares KBW Bank Portfolio
ProShares Ultra Financials
iShares U.S. Regional Banks ETF
PowerShares KBW High Dividend Yield Financial Portfolio
First Trust NASDAQ ABA Community Bank Index
PowerShares S&P SmallCap Financials Portfolio
PowerShares KBW Regional Banking Portfolio
SPDR S&P Capital Markets ETF
PowerShares KBW Property & Casualty Insurance Portfolio
Davis Select Financial ETF
PowerShares DWA Financial Momentum Portfolio
John Hancock Multi-Factor Financials ETF
Oppenheimer Financials Sector Revenue ETF
ProShares UltraPro Financials
Direxion Daily Regional Banks Bull 3X Shares
iShares Edge MSCI Multifactor Financials ETF
Personally, I prefer KRE as it is representative of domestic U.S. banks that enjoy the full benefit of the rate rise. Be warned though the good times are not without limit.
Recessions are heralded by four horsemen of the stock market apocalypse.
1. Oil price spike.
2. Fed interest rate spike and yield curve inversion.
3. Fiscal spending cutbacks by the national government.
4. Forward earnings dropping.
Let us look at each in turn:
Oil Price Spike
The blue line is the oil price. The grey bars are recessions. Except for 1960, all recessions were preceded by a spike in the oil price.
Fed Inverts the Yield Curve
Each recession since WW2 has been preceded by an interest rate inversion as the short rate exceeds the long rate. We are on that path, and despite the lessons of the past, we are doomed to repeat this folly. The chart below shows this sequence of repeated stupidity.
The pattern is so clear it can only be intentional. One can see when the inversion occurs that the recession is not immediate and there can be a lag of up to two years. But it does come, and the stock market comes down with it.
Cut to Fiscal Flows
The CBO recently released a report on the Federal budget and unwittingly showed when the next recession is likely to occur. This is shown below.
A big move down in GDP is enough of an income shock to business that a recession could well be triggered going into 2019. The CBO can rightly be criticized for its poor forecasting ability; however, over shorter terms of one to two years, it is much better. Such an income drop could well trigger a stock market panic.
The reason for the GDP drop is the expiry of Federal tax concessions, which means more dollars are extracted from the economy in taxes, and this shrinks the economy. The CBO estimates that the tax expiration will lower GDP from a growth rate of over three percent to just over one percent by 2021. This is an income loss of around $555B per annum.
A list of the expiring tax exemptions is listed below:
(Source: Joint Committee on Taxation)
Professor Wynne Godley first apprehended the strategic importance of the accounting identity, which says that measured at current prices, the government's budget balance, less the current account balance, is equal, by definition, to the private sector balance.
GDP = Federal Spending + Non-Federal spending + Net Exports.
As a percentage of GDP, all three sectors sum to zero.
Recent, current and projected annual sector balances are shown in the table below as a percentage of GDP:
2018 Congress budget*
2018 CBO estimate#
2019 Tax exemptions expire#
(Source: Trading Economics, FRED and Author calculations based on same)
*Estimate to be updated when the end of year numbers are known.
#Forecast based on existing flow rates and plans.
The table above models the sectoral flow change. If one deducts three percent of GDP from the government sector and assumes that the external sector remains the same, then the private sector balance moves into negative territory.
What this means is that the private sector goes into deficit (borrows from banks) and runs down its stock of accumulated wealth to maintain consumption. In effect, the private sector shrinks in value which will cause the price of all financial assets in the private sector such as stock, bonds and real estate to fall in value. This is a mathematical certainty.
The market may ignore business success for a while, but eventually will confirm it. As Ben said: "In the short run, the market is a voting machine, but in the long run it is a weighing machine."
(Source: Warren Buffett)
The point is that earnings, revenue and net income growth rates of the S&P are peaking now (shown highlighted yellow 2018 Q1), will be strong but flat over the next few quarters, and then fall off a cliff in 2019 Q1.
What this means is that the market also recognizes the impact the above three factors have and is adjusting its earnings outlook accordingly.
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.