For the past few weeks, the financial media has been talking about the March 15 meeting of the Federal Reserves Open Market Committee. About a month ago, Fed Funds Futures Prices were predicting a 30% chance that the Federal Reserve would increase the overnight Fed Funds rate from the current range of 50 to 75 basis points to 75 to 100 basis points. Fast forward to today, and those same futures markets suggest there is a 86% chance the Fed will increase the rate banks charge to lend balances to other depository institutions overnight on an uncollateralized basis. The following chart provided by ETF Daily News shows how quickly investors can change their tune.
When we see investor sentiment change this rapidly concerning how an institution might behave, it reminded us how vigilant we must be when managing a portfolio of risk assets. We might have a fundamental view, but if that view is contrary to the opinion held by the crowd, one can easily get run over.
In this circumstance, we agree with the crowd and believe that the Federal Reserve will increase the target range of the fed funds rate to 75 to 100 basis points. Indeed, we have held the view that the Fed might be behind the curve. Deregulation and lower income tax rates plus additional infrastructure spending should cause economic growth to accelerate. If these fiscal policy initiatives work their way into policy, the Fed might find itself behind the curve. While the Fed looks at price index associated with the PCE (Personal Consumption Expenditures), we look more broadly and consider the price action of risk assets like stocks, bonds and real estate prices. These prices have been rising quite handsomely on the back of excess liquidity provided by quantitative easing in years past and investor exuberance. The Fed runs the risk that that excel liquidity will turn into higher consumer prices as economic growth accelerates.
Keynsian Economic theory suggests that an increase in interest rates may slow the economy. It is our view that a quarter point change will have little if any impact on investor behavior, or plans for business expansion by corporations and entrepreneurs here in the USA. We thing deregulation and expansionary fiscal policy will be the driving force behind economic activity. As a result, we do not expect much of a market reaction if and when the Fed makes their announcement to raise rates on 3/15/2017. If for some reason the Fed raises the target range of the Fed Funds rate by 50 basis points, we think this would surprise investors. We think this would probably cause equity prices to fall, and the yield curve to flatten (short-term rates rise, long-term rates rise less or not at all.) Make no mistake, we think the chance of a 50 basis point rate hike is as close to zero as one can get.
In the final analysis, we do not think that a 25 basis point rate hike will slow the economy or hit the price of risk assets here in the US. The larger concern, in our view, is the effect of higher rates on borrowers in Latin America and Asia who have borrowed in US Dollars. If they have floating rate debt outstanding, then there rate will rise by 25 basis points. While this increases the cost of borrowing, we do not think the rate rise is significant.
Our concern focuses on the value of the US Dollar. The US Dollar has been rising for some time now, and a higher interest rate differential between the US Dollar and other currencies will cause even more capital to flow to the US Dollar, causing its value to rise still further.
The chart above shows that after trading sideways for a few years, the US Dollar began to risk sharply in Q2-2014. Since that time, it has risen over 20% in just under 3 years. A rising dollar will make foreign made products cheaper in the US. This is good for non-US manufactures and a headwind for US manufacturers. On the flip side, many foreign companies borrow in US Dollars but capture revenue in their local currency. This makes debt service more difficult. So looking at the chart above, if you are a foreign government or corporation, you have seen the value of your indebtedness increase by over 20% relative to your revenue generating capability. This has not seem to have been an issue so far, but if the US Dollar continues to rally, it may become an issue.
