The Fed's Rate Hike Problem: Doomsday Scenario

As we near a potential lift off for US interest rates I thought the time was ripe to put on my tinfoil conspiracy hat and consider the doomsday scenario for the rate hike. Many eternal bears have posited about a crash caused by policy failure so the scenario “bears” examination.

The past six years have been a relatively flat and lack lustre period for US economic growth with many in the nation pointing to a lack of retail and consumer spending. Despite the recent US labour statistics indicating a tightening jobs market, most of my American friends continue to tell me that times are tough and that part time employment has soared.

Obviously, a strong economy requires full employment, near the natural rate, and robust consumer demand. The US Unemployment rate, along with the Non-Farm Payroll data, are certainly showing plenty of strength but much of it is based on part time employment. The vagaries of recording mean that a citizen employed in to a job that provides just a single hour of work per week is considered a “job creation”. Subsequently, there is plenty of room for the figures to be skewed and not reflect the true strength (or lack of) within the US job market.

Enter stage right, the US Federal Reserve and their big bag of monetary policy tools to fix the current lack of growth in the economy and restore full employment. Over the past six years the venerable central bank has injected a huge amount of money into the economy to stimulate the cycle of activity. The process, known as Quantitative Easing was expected to buoy economic activity and help flatten out the cycle. However, QE isn’t as well studied as other areas of macroeconomic policy and subsequently lots of it ended up in both domestic and foreign equities. Subsequently, the doomsday scenario suggests that an extremely unstable bubble has been created in equities that is just waiting to be popped with a rate hike.

In addition, the bond yield curve has also been flattening over a period of time leading to the question of what will actually happen to financial markets when the Fed starts a cycle of tightening interest rates. The answer to that is it depends on what has occurred to the real rate of interest currently. There has been speculation recently that one of the impacts of QE is to severely depress the real interest rate and maybe even send it negative. If this is indeed the case, a rate hike cycle by the Fed could very well cause the two rates to separate significantly and thereby diminish their ability to control monetary policy.

Subsequently, a rate hike could therefore lead to a devilish situation where the Fed’s ability to impact money demand is diminished, whilst the US economy falls in to a recession. The scenario would likely start with a sharp fall in US equity and bond markets which would lead to panic over the solvency of banking institutions. Such a scenario could very likely bring about a severe recession and subsequent depreciation of the US Dollar.

The eternal bears would have you believe that this scenario is the likely play for the coming months and that, subsequently, you should position your holdings in to precious metals. However, often you need to look behind the façade of the market commentator to see that they often have interests in Gold and Silver.

The reality is that the coming rate hike is historically unprecedented given a tightening cycle into a flat economy. Subsequently, none of the purported scenarios are really valid for any sort of analysis especially given the unique role that QE has played. I suspect strongly that the rate hike will ultimately be rewound sometime in 2016 but fail to see the event horizon approaching that the bears do. However, I do suspect that US equities are in for a rough ride, especially those without strong fundamentals that have benefited from the recent capital injections.

Ultimately, like a broken watch that is right twice a day, the bears will likely have the last laugh but not to the extent they think. The US is in for a bumpy ride but to suggest a total collapse underscores a misunderstanding of the economies position in the world. In closing, to my tin foil hat wearing brethren, I salute you, and please send any comments of support you might have for me care of the US Federal Reserve.