Eye on the Markets - 2017

Improving Economy and the Federal Reserve

By Ketu Desai

While much of what you read and see would have you believe that the recent stock market rally is entirely due to the new president, the reality is that while his policies would be pro-growth, the economy was trending up even prior to him taking office.

As the economy has improved, the Federal Reserve has started to and will accelerate the removal of stimulus and raise interest rates. In this article, we will review what has occurred, highlight where we are now, and the impact of higher interest rates.

In 2008, we had one of the most significant recessions and financial crises of recent economic history. The entire banking system was on the verge of collapse. This extraordinary crisis created the need for extraordinary measures by policymakers. During this time, and the subsequent years, the Federal Reserve and global central banks provided unprecedented stimulus to the global economy. The Federal Reserve cut interest rates to effectively zero for many years. The impact of this is that it promotes people to borrow money, as it is nearly cost-less to do so, to work on new projects and help the economy grow.

It further incentivizes people to spend or invest their money, as keeping it in the bank does not earn you much. To provide further support to the economy, central banks engaged in a policy called quantitative easing. Without providing the technical details, this policy is basically the Federal Reserve buying longer maturity bonds to create money in the financial system. This policy again promotes economic growth. This policy has resulted in developed world central bank balance sheets ballooning to ~$15 trillion, and they own almost half of $43 trillion in developed world government bonds.

Fast forward to today, the policy measures have worked in the sense that we are now seeing stronger economic growth around the world. Inflation in the United States is near its 2% target. Both Japan and Europe are witnessing improved economic growth. The United States has started to normalize policy in that it has raised interest rates slightly from zero. It is expected that the Federal Reserve raises interest rates three times this year, each by 0.25%. The first of these increases is expected in March.

As interest rates rise, the goal is to prevent the economy from over-heating. An increase in interest rates, increases the cost of financing, and also increases the opportunity cost of taking your money out of the bank, thus slowing the economy down. Changes in interest rates have an important impact not just on financial markets, but also the lives of average Americans.

The level of interest rates impacts the lives of most Americans. For instance, as interest rates rise, you will over time see slight increases in the amount of money you earn from your savings in the bank. If you plan to borrow money, the cost of a mortgage, construction loan, business loan, will all increase. As the cost of money increases, many of these assets that are heavily financed could see a decrease in volume or price or both. For instance, house prices may decline because a buyer's mortgage payments increase, thus lowering the affordability. Specifically, an increase from 4% to 5% in mortgage rates for a $400,000, 30-year mortgage, increases the monthly payment from about $1900 per month to about $2150, or nearly $90,000 more during the life of the mortgage. This is a meaningful amount for many borrowers.

Changes in interest rates also impact financial assets. As interest rates go up, the price of your fixed income portfolio will go down. In particular, if you hold bonds, whether corporate, sovereign, or municipal, the price will go down. It also impacts the value of gold.

The impact on gold can vary depending on what is going on in the economy and world, however, generally, as interest rates rise, gold prices tend to decline. Gold is an asset that does not provide yield or interest, or cash flow, it is a safe haven asset. As interest rates increase, for many investors, it is better to keep money in cash at the bank than to hold a yield-less asset such as gold.

The impact of changes in interest rates on equities really depends on many other factors. From a textbook perspective, where all other things are held constant, higher interest rates have a negative impact on stocks.

Although if the economy is improving, and investors want to unload their bond portfolios, stocks could continue to rise as interest rates rise. Stocks and bonds have moved in tandem in recent years, largely due to Federal Reserve policy. It will be very interesting to see how the relationship changes as the policy normalizes.

The combination of the election, economic growth, and changes in Federal Reserve policy could mark an important turning point for markets. It could mark a change in how various asset classes move in relation to each other. It could change the forward-looking return dynamics for many asset classes. Changes in interest rates and interest rate policy reaches nearly all aspects of American economic and financial life. It will be extremely interesting how the Federal Reserve follows through on their forecast. Last year, they expected multiple rate increases, and only did one.

We will have more information in the coming weeks and months.

Stay tuned!