Top Investment Stories of 2015 and 2016 Expectations 4: Houston We Have Liftoff

Rising Interest Rates

Overview

2015 marked the first increase in the discount rate set by the Federal Reserve since June of 2006. The amount of the raise, from a range of 0-25 basis points to 25-50bp means little on its face. In other words a 25bp hike itself does little to change the banking economics, but the change in sentiment matters...in fact it matters a lot. 

Before we get into the effects of this we need to understand why the Fed felt now was the right time to raise interest rates after delaying it so many times. We talked about it here in a blog post a few months back but to summarize:

1. The Fed has a dual mandate of full employment and steady prices (there's a third but it's a function of the other two)
2. The employment scene appears to be very strong with unemployment in the low 5% range
3. Inflation is still far below the Fed's two percent goal but they see evidence it will stabilize and rise in 2016 due to (i) wage pressures from strong employment and (ii) "transient factors" such as oil prices stop going down or at least stabilize
4. Monetary policy is forward looking and takes months to flow through the economy. In other words they don't want to get caught in a situation six months from now where employment is still very strong and inflation starts to rise and they have to raise rates multiple times and/or by a large amount (50bp+). That could create a shock to the economy they want to avoid
5. There is likely an element of if the economy slides into recession and rates are 0% what tools would they have at their disposal. Everyone talks about negative interest rates but who wants to be the Fed President who implements that?
6. They basically boxed themselves in and said they were going to raise rates in 2015 so the markets probably would have taken it even worse if they hadn't raised as it would have been interpreted as the economy isn't strong enough to stand on its own

So net, net they decided it was time. But at the same time they used the words "gradual increases" rather than "measured increases".  Why does this terminology matter? Well gradual means they will consider it each time and make a decision to increase approximately every other meeting (eight meetings in 2016, so four increases). Measured means basically every meeting so eight increases in the next year. One final note before we discuss the effects of this increase: futures are currently factoring in two increases this year of 25bp each...the Fed is still at four increases...this will have to sort itself out. 

So why does a small increase of 25bp make such a difference? We'll list the reasons here and then discuss them in some detail below:

1. The Fed basically removed what is called the "Fed backstop" 
2. Rising interest rates decrease the future value of cash flows thereby decreasing the current value of businesses 
3. Rising interest rates contribute to the increase in the US dollar relative to other currencies 

The Fed Backstop

What is the "Fed Backstop"? Essentially it is an investor psychology that says if things go wrong and the markets start doing poorly the Fed will step in and do something to support prices. The Fed actively backstopped the markets with quantitative easing since late 2008. Here is a good chart showing the S&P 500 during times of QE and the S&P 500 without QE:

Source: http://www.yardeni.com/pub/monpolicyqe.pdf

QE helped the stock market as suppressed interest rates increased the future value of businesses due to lower interest payments, and forced investors to look further out the risk spectrum leading trillions of dollars to buy stocks. Additionally, each time the markets faltered and the Fed stepped in to support them it provided further confidence that downside was limited, leading to more risk taking. The Fed took away the punch bowl in late 2014 and since then the market is down.

Despite the market being down, the Fed has given back the punchbowl and has in fact tightened monetary policy, which has led investors to believe the Fed no longer intends to support the market. If investors no longer believe the Fed will step in and rescue them if the market gets in trouble then this increases downside risk for investors which means they are likely to reduce exposure to the stock market. Without the backstop, the focus shifts from how supportive the Fed is of the recovery to how meager the recovery has actually been. As this focus changes, investors become more scared, which naturally leads to selling.

Equity Cash Flows / Valuations

Finance 101 teaches the value of equities is equal to their future cash flows discounted at an appropriate rate of return. That rate increases as other investing options become more attractive. In other words, if interest rates go up and a 10-year Treasury bond starts yielding 4%, 5%, etc. the value of equities is reduced because their future cash flows are discounted back at higher rates. This is not only true in terms of valuing cash flows but also from a sentiment perspective. As rates rise investors find the security of bonds more and more appealing, leading them to sell equities. 

Buffett made this point at the last shareholding meeting in May15, "If yields stay where they are now stocks will have been very cheap right now, if they rise they won't have been so cheap...". 

Of course yield assets will be the most affected. At the same time this is and already has created opportunities as people flood out of certain company's with stable yields. Unless rates increase significantly and/or we enter a recession, some of the sell-offs will prove overdone. 

The US Dollar

As interest rates rise in the US due to a strengthening US economy, the value of the US dollar increases. A strengthening dollar is ironically counter to the Fed's desire to increase inflation in the US. Why is this?

The US runs a massive (hundreds of billions of dollars per year) trade deficit meaning we import far more than we export. When the dollar is stronger we import deflation meaning we can buy more product for the same amount of money. This is good for you and me as consumers because we can buy things cheaper than we would be otherwise. However it does keep a lid on inflation and has a negative effect on those whose jobs depend on exports to other countries (because weaker foreign currency can buy less domestically produced goods). 

A stronger US dollar is also bad for commodities as they tend to be quoted in dollars, meaning the contracts are settled in dollars. This is due to the US dollar's status as the world's primary reserve currency. It seems counter-intuitive but as the value of the dollar increases the value of the commodities being settled in US dollars decreases. It's the same concept as above, as the currency increases if the amount of what you are buying doesn't change it effectively becomes cheaper. 

This is having a very negative effect on commodities such as oil which is already under significant pressure as OPEC has effectively declared a full out price war. It certainly is not a perfect correlation but in all things equal a strengthening dollar decreases the value of these commodities. 

The big question, call it the trillion dollar question, is whether or not these lower commodity prices, namely oil for the US given how much we produce, will strengthen or weaken the economy. On one side, economists estimate the lower oil prices have created savings of up to $100B a year for consumers in the US from lower gasoline and other fuel products. This cash in the consumers hands should lead to increased spending in the economy. 

On the other hand the US oil industry is very large and a significant number of jobs will be lost as a result. This isn't just those working on oil rigs, this also includes all of the suppliers such as steel companies, equipment companies that provide trucks, etc. This is a very very large industry. It is reminiscent of the auto industry in late 2008/2009 that Bush/Obama were forced to bail out (although different in many respects because its not an oligopoly and a democrat would never be caught dead bailing out those "rich oilmen"). This isn't just a few oil companies going out of business, there is a massive public and importantly private supply chain that is massively impacted. 

However, like most busts that come after booms, the strongest companies will emerge stronger than ever because they had the balance sheets to make significant acquisitions at distressed prices. But in the mean time it will undoubtedly be very painful.

Conclusion

While the Fed's small move in rates barely registers on the radar of interest rate movements, the collapse in confidence as a result of the accompanied sentiment shift has been very meaningful. Given the most recent action in the stock market and high yield markets, we do not expect the Fed to maintain the pace of interest rate increases its last announcement alluded to. Instead, we expect the Fed to likely go back a bit on its hardline stance and try to convince the market that it remains extremely accommodative.