posted on 21 December 2016
This past week, Janet Yellen and the Federal Reserve finally did something they have been promising to do for an entire year - raise interest rates.
Mind you, the lift in interest rates from 0.50% to 0.75% has hardly moved the Effective Federal Funds Rate BUT the London Interbank Offered Rate (LIBOR), which is what affects a variety of actual interest payments, has already risen sharply in recent months. In other words, the Fed is already well behind the actual market in terms of tightening monetary policy.
Here is Janet’s statement on the rate hike:
And with that, the Fed’s “Dot Plot" shows the Fed plans to hike rates 3-times during the next year moving the Fed Funds Rate to 1.5%.
Oh, wait a second, that was what she said in 2015.
Here is what she said this past week:
And once again, the Fed’s “Dot Plot" suggests the Fed hopes to hike rates 3-times within the next year.
The problem, and as I will dissect in a bit more detail, is the expanse betweens the Fed’s “fantasy" and economic realities. This is shown in the table below which documents the median of the Fed’s economic projections versus reality. In every single year, they have been wrong.
Yet, besides being the world’s worst economic forecasters, the market still believes statement she makes. Let’s analyze her comments and compare them to reality for a moment.
Depending on where you start counting, 15-million jobs may have been added to the U.S. economy. However, there is an important distinction to be made. As shown below, the actual number of jobs created is 4.77 million fewer than the increase in the working-age population. (June 2009 to Present).
This explains why, outside of mandated minimum wage and Supervisory employee salary increases, wages and economic growth have remained exceptionally weak.
And inflation-adjusted hourly wages are also headed back to zero growth which hardly suggests economic acceleration.
Even the Fed’s own Labor Market Conditions Index (LMCI) suggests that something isn’t quite right in the economy as its 12-month moving average has now dipped below zero for an entire quarter. As I noted last Thursday, she is right about one thing:
Here is the problem.
The only inflation in the market currently is coming from spiking health care costs and rental rates as shown in the breakdown of the Consumer Price Index. It is clear where inflationary pressures have come from over the last 5-months.
Inflation can be both good and bad. Inflationary pressures can be representative of expanding economic strength if it is reflected in stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices. That would be the good.
The bad would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.
If we take a look at import and export prices there is little indication that inflationary pressures are present.
In fact, there are more deflationary forces in the economy currently than inflationary. Furthermore, with Housing and Medical Care extracting dollars from consumers into areas that do not boost economic growth, expectations of higher “good inflation" that leads to stronger employment, wage and economic growth are likely misplaced.
Unfortunately, she will likely be proved wrong once again as she has been in every year since 2011 as “hope" is eventually faced with economic realities.
First, “record levels" of anything are records for a reason. It is where the point where previous limits were reached. Therefore, when a “record level" is reached it is NOT THE BEGINNING, but rather an indication of the MATURITY of a cycle. While the media has focused on employment, record stock market levels, etc. as a sign of an ongoing economic recovery, history suggests caution. The 4-panel chart below suggests that current levels should be a sign of caution rather than exuberance.
So, if you are betting on a strong economic recovery to support excessive valuations and extremely stretched markets, you could be setting yourself up for disappointment.
Oh, and don’t think for a moment that rising interest rates, combined with a strongly rising dollar, is somehow “good for stocks."
It has never been.
Hedging portfolio risk remains prudent.
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