Ready for the Rate Hike?

The booming labor market has given the Fed all the cover it needs to raise interest rates as soon as next month. The Fed not only signaled its own intentions, but dropped a broad hint that other central banks around the world should take a long, hard look at monetary policy. In a world of persistently low rates, low inflation and low growth, we may finally be seeing the results of nearly a decade of near-zero interest rates. Instead of growth and infrastructure development, which was the promise of accommodative monetary policy, we got stagnation, deflation and very little growth. Now the Federal Reserve is signaling that it’s ready to throw in the towel and admit that flooding markets with cash has led to a lot of unintended consequences, most of them bad.

The Fed is facing another quandary and that’s how to address the next recession now that easing, the go-to recession policy, doesn’t seem to be working anymore. Some of those new tools are controversial and some need Congressional approval. The elephant in the room for the Fed is the $4.5 trillion it still has on the balance sheet from the last recession. Many elected officials are uncomfortable with the Fed essentially running up that big a bond-buying bill, but some members of the Fed board are suggesting those numbers are the new normal.

Our Banking System Isn’t Built for QE

One of the unintended consequences of the war on currency has been the effect on banks and lending institutions. When companies can sell bonds to the government, which is essentially what’s happening with Quantitative Easing, or QE, there’s no margin in it for our banking system. So to make money banks have to make riskier loans, which get bundled into assets and sold to small investors. If that sounds familiar it’s because that’s exactly how the 2007 meltdown came about; subprime real estate loans that were part of larger securities went bad – leading to the Great Recession.

Asian Markets React

The hawkish messages from the Fed sent the yield on short-term bonds higher in Asian markets which put downward pressure on equities. Hong Kong’s Hang Seng index dropped sharply when trading opened on Monday. But what was bad news in China was good news in Japan when the dollar strengthened against the yen. In an export-dependent country like Japan, a stronger dollar makes products trafficking through Japanese ports more attractive to buyers.

Rate Hike Already Priced In

For commodities like oil, gold and silver the Fed hawkishness has introduced some short-term declines. But this selling is probably overdone, as a rumored quarter-point interest rate bump has been hanging in the wind for nearly a year. Historically interest rates and gold prices move in opposite directions because investors feel they can make a better return from” government bonds.  But whether that holds true today is a question mark as interest rates are still near historic lows.

Business Debt Clouding the Future

The biggest concern we should have about an interest rate hike is the mountain of corporate debt hanging over our economy. When the Fed was buying corporate bonds, companies were all too willing to take the money with interest rates at practically zero. The Fed was hoping corporations would take all that cash and build their businesses, construct new facilities and hire new workers.

But instead many corporate borrowers used all that extra money to buy back their own stock and pay outsized dividends, creating the appearance of growth and, not coincidentally, reaping giant bonuses for their CEOs. So after all that QE, what we have is a lot of debt on corporate America’s books that will reduce profits for years going forward. It also means those companies will be paying more in debt service when interest rate hikes go through.

Given the circumstances, it’s no surprise that the Fed is—belatedly—looking for new tools to address the next recession. The tools our financial shepherds have today are old and outdated, meant for an investing world that no longer exists.