By now, even the most economically disinterested person has caught a whiff of the vaunted interest rate hike being debated by the Federal Reserve. There is an unimaginable amount of literature and opinion discussing the ramifications of such a decision. The vast majority of onlookers have steadfastly claimed that climbing interest rates would catalyze a precipitous drop in the equity and fixed income markets—a view that is only partially accurate.
There is certainly sound logic behind the expected drop in the fixed income market. More secure investments, like Treasuries, will experience higher demand and thus boost corresponding yields (1, 2). Conversely, riskier securities, most notably commercial paper and sub-investment grade debt, will suffer. The utopian world with impossibly low interest rates coaxes investors to embrace ambitious and risky options. Thus, rising interest rates will invariably push investors out of such securities and into money markets or Treasuries. The belief that the fixed income asset class will feel the sting under rising rates is a rational assumption: it is the realistic half of the sweeping, cataclysmic conclusion many are championing.
Perhaps the more curious prognostication is that the equity markets will shudder in the face of interest rate hikes. This is a complex issue further complicated by the recent turbulence in the markets. The past two weeks have displayed the fragility of the equities market, and paradoxically led many to revive their anti-hike crusade. This defensive view simply ignores the current value of the market and instead focuses heavily on the swift demise of equities. By most accounts, the market is still at least slightly overpriced, yet the fear instilled by the uber-correction is paralyzing the Fed’s ability to decisively engage in tight policy. The anticipation of the hike is causing market distress, placing the economies around the world in precarious positions.
When the Fed announced an end to its quantitative easing policy, it hinted at economic confidence. As Fed Chairwoman Janet Yellen announced the plan to “raise the federal funds rate [and] normalize monetary policy,” she affirmed economic progress (3). You don’t take the training wheels off until you know how to ride the bicycle. Following Ms. Yellen’s speech, the markets enjoyed a substantial boost, no doubt stimulated by the reassuring remarks. The market, yearning for confidence, soared in the face of a looming interest rate hike. Ms. Yellen’s statement did provide hope, yet investors largely swept the rates hike news under the carpet and used the positive outlook as fodder for yet more speculative investments.
Speculation is what drives equities to unpredictable and often unreasonable heights. Keeping interest rates artificially low for such a prolonged period “covers up other issues,” explains former Treasury chief Henry Paulson (4). With easier and more importantly cheaper access to money, investors poured into US equities, creating volatile and dangerous market conditions. Once the surge ran out of fuel, the entire system sagged into oblivion—the extreme regression we’ve been witnessing over the past few weeks. Those burned during the apocalyptic crash of 2007-08 licked their wounds and dove back into the speculation game, emboldened by a long period of interest rates hovering at practically zero.
This is all to say that the Fed must make a decision soon in order to squelch the rumors and fears passing through every investor’s mind. At this point, the only way the Fed can hope to calm down the markets is by providing some sort of legitimate, well-structured plan for executing its interest rate hikes, if that is the course of action it chooses. Throwing in qualifiers with every major announcement, as Ms. Yellen did in her July 10 address, only serves to intensify the cloud of chaos currently enveloping both Wall Street and Main Street. To terminate quantitative easing and theorize interest rate hikes are strong messages, and the Fed must follow through—or risk making an equally strong statement: the US economy is unreliable and has not approached acceptable levels of recovery. Surely six years of progress cannot be overshadowed by some poor jobless data and a severe correction.
It would be foolish to think that a rate hike would be without any consequences. Addressing the very real concerns of some skeptics is an important step toward understanding how we found ourselves in the middle of a very real equity bubble. One of the key arguments focuses on the individual investor and his/her ability to invest. Interest rates going up generally means homeowners with adjustable-rate mortgages (ARMs) will be forking out more money each month in debt service. This is a concern when the average homeowner owes $157,154 on his/her mortgage (5). The extra monthly payment would sap the homeowner’s ability to put money into a retirement account or invest, thus hurting the overall market. The glaring hole in this elaborate theory is that only 55% (6) of American adults, many of whom are nearing retirement, are invested in the market in any way. Summarily, nearly half of the population is not in any way invested in my market, and those who are involved are generally older folks who have lower monthly payments (7) on fixed mortgages. The mortgage crippling theory is simply not mathematically sound, barring sharp unforeseen behavior.
A more reasonable argument for downward equity trajectory following a rate hike is the effect such an action would have on companies’ cash flow. For value investors, the free cash flow (FCF) of a company is crucial, and raising rates would increase capital expenditures, thereby hurting FCF. A common method of valuing equities is through a discounted cash flow analysis, to calculate the present value of an investment. A lower FCF would dampen a DCF conclusion, creating a potential bearish sentiment amongst these investors. While value investing and examining a company’s financial statements is a solid method of seeking reliable long-term opportunities, fewer and fewer people are turning to these techniques these days. High-flying technology companies have ushered in a new era where P/E ratios, book values, other traditional fundamentals have been spurned in the face of high-upside glamorous speculation (8). As such, the number of methodical investors relying heavily upon these figures is shrinking, limiting the overall market downside risk associated with raising rates.
An interest rate hike is the sensible course of action based on one very simple piece of logic. The Fed felt strongly enough about economy in July to publicly disclose its plan to raise rates, and very few things in the meager three-month interim should be cause for aborting or derailing such a plan. Six years of growth cannot be slighted in favor of the recent shakeup. If the Fed continues to vacillate, it will induce finicky and inconsistent behavior from investors, perhaps more dangerous than an outright selloff. Frankly, the economy could use a vote of confidence from the Fed right now, and extending the artificial illusion of easy money is not the path to a prosperous nation.
“Daily Treasury Real Yield Curve Rates,” U.S. Dept. of Treasury, 2015. Accessed at: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=realyieldYear&year=2015
“Treasury Yield Curve Rates,” Quandl. Accessed at: https://www.quandl.com/data/USTREASURY/YIELD-Treasury-Yield-Curve-Rates
Janet Yellen, “Recent Developments and the Outlook for the Economy,” Federal Reserve, 10 July 2015. Accessed at: http://www.federalreserve.gov/newsevents/speech/yellen20150710a.htm
Kasia Klimasinska & Guy Johnson, “Ex-Treasury Chief Paulson Says Low-Rates Fuel Asset Bubble Risk,” BloombergBusiness, 11 May 2015. Accessed at: http://www.bloomberg.com/news/articles/2015-05-11/ex-treasury-chief-paulson-says-low-rates-fuel-asset-bubble-risk
Andy Kiersz & Libby Kane, “How Much American’s Owe on Mortgages in Each State,” Business Insider, 13 October 2014. Accessed at: http://www.businessinsider.com/mortgage-balance-state-map-2014-10
Justin McCarthy, “Little Change in Percentage of Americans Who Own Stocks,” Gallup, April 2015. Accessed at: http://www.gallup.com/poll/182816/little-change-percentage-americans-invested-market.aspx
“Average American’s Mortgage Payment,” The Motley Fool, October 2014. Accessed at: http://www.fool.com/investing/general/2015/03/23/heres-the-average-americans-mortgage-payment-by-ag.aspx
Conor Dougherty, “Overvalued in Silicon Valley, but Don’t Say ‘Tech Bubble’,” The New York Times, 22 May 2015. Accessed at: http://www.nytimes.com/2015/05/23/technology/overvalued-in-silicon-valley-but-not-the-word-that-must-not-be-uttered.html?_r=0