What to Do When Interest Rates Rise

Last year, when the Federal Reserve realized that the inflation, which was earlier thought to be “transitory,” might be feeding on itself and soon spiral out of control, it acted swiftly to respond with an aggressive interest rate hike cycle, one of the quickest on record.

As a result, we have gone from living in a world of virtually free money, marked by a target federal funds rate of 0% to 0.25%, for more than 12 years since the global financial crisis to a world of constricted credit, with a target rate at 4.50% to 4.75%, the highest since 2007.

Right on cue, the market and economy responded to the end of the era of easy money with withdrawal tantrums. Although the Fed has been able to bring down CPI inflation from a 40-year high of 9.1% in June 2022 to 6.4% in January 2023, it has come at the cost of increased market volatility, stressed margins due to increased borrowing costs, and bank runs due to bond price devaluations.

Given that the federal funds rate appears to be nothing short of a force of nature for the capital markets and the economy at large, its deeper understanding would serve market participants well.

What is the Federal Funds Rate?

The federal funds rate is the interest rate that banks charge other institutions for lending excess cash to them from their reserve balances on an overnight basis.

Legally, all banks are required to maintain a percentage of their deposits as a reserve in an account at a Federal Reserve bank. This mandated amount is known as the reserve requirement, and compliance of a bank is determined by averaging its end-of-the-day balances over two-week reserve maintenance periods.

Banks, which expect to have end-of-the-day balances greater than the reserve requirement, can lend the surplus to institutions that expect to have a shortfall.

The Federal Open Market Committee (FOMC) guides this overnight lending of excess cash among U.S. banks by setting the target interest rate as a range between an upper and lower limit. This target interest rate is called the federal funds rate. Continue reading "What to Do When Interest Rates Rise"

What Will The Fed Do In March?

The Federal Open Market Committee meets next week, at which time it is expected to raise its benchmark interest rate another 50 basis points, to a range of 4.75% to 5.00%, if we correctly interpret Fed Chair Jerome Powell’s testimony to Congress last week, when he said “the ultimate level of interest rates is likely to be higher than previously anticipated.”

Before that, the market had expected a 25-basis point increase, equivalent to its most recent hike at the Jan. 31-February 1 meeting. As we know, his comments sent stock and bond prices sharply lower.

Since then, though, we’ve had some serious news coming out of the banking system, namely the failure of SVB Bank and the closure of Silvergate Capital (both regulated by the Fed!) and worries that some of the largest U.S. banks (also regulated by the Fed) are sitting on some huge, unrealized losses in their government bond portfolios.

In this atmosphere, is a larger than expected rate increase next week—i.e., 50 bps rather than 25—justified?

Or should the Fed maybe show a little restraint and raise the fed funds rate only a quarter point?

And if it does, what will be the likely market reaction?

In his Capitol Hill testimony, Powell focused – as you would expect – on the U.S. economy, namely its stronger than expected recent performance, particularly in the jobs market, which in February gained another 311,000 jobs even as the unemployment rate rose slightly to 3.6%.

The Fed seems hellbent on making up for its past errors of overly long, overly loose monetary policy by ramming through rate increases no matter how much harm they might cause.

Ignoring the second component of its Congressional mandate, namely promoting full employment, the Fed is instead totally focused on slaying inflation as fast as possible, even though getting from the current rate of inflation – 6.4% in January — back down to its 2% target will no doubt take some time.

After all, the Fed only started raising interest rates back in March 2022, when the fed funds rate was at or near zero. Continue reading "What Will The Fed Do In March?"

Watch The Inflation Numbers

During the first few trading days of March 2023, we watched the stock market falter, housing demand cool, the 10 Year Treasury Bond rises to a 4% yield, and the 30-year fixed mortgage increase above 7%.

This all came after several hotter-than-expected inflation reports hit investor confidence.

The Federal Reserve has also cut back on its interest rate hikes, going from an increase of 75 basis points to 50 basis points, down to just a 25 basis point increase. Those reduced rate hike increases were due to inflation reports trending in the right direction.

However, reports coming out now show inflation has not yet been tamed after the hikes were slowed. And this is having both big and small investors and some Federal Reserve members calling for faster rate hikes in the future.

David Einhorn, who had a 36% return in his hedge fund in 2022, recently said investors should still be bearish on stocks and bullish on inflation in 2023. Einhorn was short US equities in 2022 and performed very well for his hedge fund investors.

Former Pimco Chief Executive Officer Mohamed A. El-Erian recently wrote in Bloomberg that he favors a 50 basis point rate hike at the coming Fed Meeting. He further noted that three Fed Members have publicly announced their wiliness to increase rate hikes by 50 basis points at coming meetings, despite all agreeing to raise rates by just 25 basis points at the Feb 1st meeting.

Federal Reserve member James Bullard is one of those three Fed members who have come out and announced he favors faster rate hikes in the future. Bullard believes inflation can be beaten in 2023, but only with aggressive rate hikes until it begins to come down. His concern is that inflation doesn’t come down but re-accelerates, and we are forced to relive the 1970s.

With the next Federal Reserve meeting just a few weeks away, now is the time to start planning your portfolio. There is a good possibility that even if rates aren’t increased aggressively at the March meeting, they will be increased multiple times over the coming meetings. Continue reading "Watch The Inflation Numbers"

Higher Rates Are Here To Stay

If you believe what the inverted Treasury yield curve is saying, you must believe that, eventually — but probably sooner rather than later — the Federal Reserve will start lowering interest rates in response to the economic recession it will have caused by raising rates by more than 400 basis points in the past year.

But based on the strength of the economy despite those higher rates, it’s looking more like rates well above 4% - and possibly 5% — are going to be around for a long time to come.

But that’s not necessarily such a bad thing. For all those younger than 40, 4-5% long-term interest rates had been the norm for decades.

It’s only in this century that we’ve become accustomed to super-low interest rates, engineered by an activist Fed to insulate consumers and the financial markets from seemingly one financial crisis after another.

But that era looks to be over. And it looks like we’re managing.

Even though inflation appears to have peaked and is moving steadily downward, the Fed is likely to keep rates fairly high for quite a while, certainly the rest of this year and probably 2024 and beyond, absent yet another global financial crisis, to make sure the inflationary beast is truly slayed.

Even on the unlikely chance that the federal government defaults on its debt later this year if Congress can’t agree to raise the debt ceiling, the Fed isn’t likely to start lowering rates for a long time, despite what many investors hope and the inverted yield curve would indicate.

As we know, an inverted yield curve is when short-term rates are higher than long-term rates, which is the exact opposite of the natural order of things.

Long-term debt usually carries higher rates because a lot more can go wrong over, say, 10 or 20 years, than it can over just a couple of years or less. But that’s not what we have now. Continue reading "Higher Rates Are Here To Stay"

My Latest "Prediction" For 2023

Back in March I posited the notion that the S&P 500 would need to fall to about 2,900 before all of the froth that the Federal Reserve had injected into the market through its various monetary stimulus programs dating back to the Great Recession had finally burned off.

On Christmas Eve the S&P closed at 3844, which would put it 19% below its all-time high of 4,766 on December 27, 2021, or about a year to the day.

In recent days some market prognosticators have been warning that the market is poised to fall another 20%, which would put the index at about 3,000, or slightly above my guesstimate.

So do I feel vindicated, if that is the right word? No, and I hope I’m wrong anyway.

First, my guess was not a prediction, just a quick back-of-the-envelope calculation based on my assumption that the Fed was responsible for about half of the stock market’s 600% gain between the March 2009 bottom of 683 and the time I made my comment.

So, if we cut that 600% gain in half, that would reduce the S&P’s gain to a still respectable 300%, or a little below 3,000.

Not an educated estimate, maybe, but I thought a reasonable guess—a worst case scenario, if you will.

Second, we don’t know if these bears will turn out to be right. I hope they’ll be wrong.

I now believe the Fed won’t have to drive the economy into the tank in order to get inflation down to where it wants it to be, probably in the 2.5% to 3% range.

Remember, about two years, in what was considered to be a major policy shift, the Fed said it was willing to let inflation “overshoot” its long-term target of 2% for a time, as it indeed it did.

Now it looks like inflation is dropping a lot faster than most people thought, and the Fed itself is now forecasting that inflation will fall to 3.1% next year before declining in 2024 to 2.5% and 2.1% in 2025, i.e., putting it at its long-term target. Continue reading "My Latest "Prediction" For 2023"