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The Slow Federal Reserve Trainwreck:  Oops & Oops Again

Posted by kdadmin on November 2nd, 2016.

The Slow Federal Reserve Trainwreck:  Oops & Oops Again

Today, at 2pm Eastern, we’ll get to see the next installment of The Slow Federal Reserve Trainwreck. Brought to you by Oops & Oops Again …

Will they raise the Federal Reserve Rate? Are they going for a trilogy? Can I call it “Oops of the Third Kind?”

The Slow Lane

Can you even remember when we last had a rate hike? I mean, could the Federal Reserve go any slower? Waiting for “optimal market conditions” to raise the Federal Funds Rate is like watching the play, Waiting for Godot. (Spoiler Alert): Godot never shows, and you just spent two hours watching a couple of dolts obsess about it on stage. Do you want you ticket money back? I would.

Does this remind you of anything else that’s been all over the news for the last 18 months? Two dolts obsessing about things on stage and much of America just wants its money back? For a refresher, try my article, The Election: How Will It Affect Your Portfolio & Financial Freedom. But I digress …

In any case, there’s a reason for Federal Reserve’s sloth. Chairman Paul Volcker.

The Slow Federal Reserve Trainwreck: Oops.

In the late 1970’s, the US Economy struggled with rampant inflation. There were many factors, including the oil crisis, government overspending, and a self-fulfilling ideology in which higher prices lead to higher wages which lead to higher prices.

By 1980, Federal Reserve Chairman Paul Volcker was determined to stop inflation, so throughout that year and into 1981, he kept raising the Federal Funds Rate until it hit 20%. (Seethe chart above.)

While he succeeded in stopping inflation, he also succeeded instopping the economy (Real GDP Growth); and sent the USA into a deep recession.

Oops.

The Slow Federal Reserve Trainwreck: Oops Again …

You know how history has a tendency to repeat itself if we don’t study it? Well, in 2004 the Federal Reserve went on an abrupt tear to raise rates again. From May, 2004, to June, 2006, it raise the Federal FundsRate from 1% to 5.25%. That’s a 400% increase in two years.

Of course, banks use the Federal Funds Rate as a reference point when setting mortgage rates. During this two year period, the 30 year mortgage rate increased by 40%, from 5% to 7%. The 5/1 adjustable rate mortgage increased by 85%, from 3.5% to 6.5%. But the real killer was the 6-Month LIBOR, the foundation of most adjustable sub-prime mortgages. It went up by more than 400%, from 1% to 5.5%. Now, if someone had an adjustable rate mortgage and saw their payment increase by 40% to 75% because of the 85% to 400% increase in the underlying rate, it’s extremely unlikely that they would have been able to afford their new payment.

What happened next? Default. Multiplied by tens of millions of loans.

Does anybody remember the financial crisis of 2008?

Oops Again.

Oh sure, there were “lots of reason,” like overly liberal lending practices, stupid speculative bets that brought down Lehman Brothers, mass unemployment, falling corporate earnings, the usual. But look at the chart below. I’d say that the direct correlation between the Federal Funds Rate and the 6-Month LIBOR, followed by an immediate and mirrored increase in First Mortgage Default Index, is pretty damning. But that’s just me …

Is “Oops of the Third Kind” Next?

Only time will tell. But not much time.
The economic consensus is that the Federal Reserve will not raise the Federal Funds Ratein November, but WILL do so in December. The futures markets have pegged the likelihood of an increase in the Federal Funds Rate at about 5% in November, 75% in December, and 20% later altogether. While most economist can agree that the Federal Reserve is more “hawkish” (favoring a rate increase) now than it has been previously, most also think that the Federal Reserve will tread carefully this close to an election.

(Unlike FBI Director, James Comey.)

Instead, the Federal Reserve will likely use stronger language to reinforce a rate hike decision in December and/or pave the way for additional hikes in 2017-2018. On a long term basis, many economists believe that the trajectory for the Federal Funds Rate is to end up with it at 2.75% by the end of 2018. This is still a somewhat aggressive pace, with a 2.25% increase in 2 years.

What Does This Mean to You?

A rising Federal Funds Rate likely equals falling corporate earnings which equals falling stock prices. If you’re a stock investor, it means that your good days are likely behind you. If you’re a bond investor with a solid portfolio, it likely means continued, and relatively steady, returns. If you’re my client, it means we’ll likely be adding to our positions shortly.

The Next Steps?

Learn about bonds. Start here.

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