One aspect in financial markets that has never happened before, that has just happened and is still in the process of process of happening, is the pace of increase in the United States Federal Funds Rate. The current pace at which the Federal Reserve has increased rates is the fastest it has been in history.
In March 2022, the Federal Funds Rate range was 0% to 0.25%. In the first half of March, the first increase of 0.25% took place, increasing the rate range to 0.25% and 0.50%. From here another nine rate increases took place in rapid succession lifting the rate range to its current level of 5% and 5.25%. We are standing at a point in time where no-one has been ever before, and now we wait.
We now wait for how the economies and markets of the world will react to the consequences of these rate hikes. But why the wait?
Can we once again invite Goldilocks in for some porridge after she has wandered off for a while?
Depending on the models referenced, it takes roughly between 12 and 18 months for monetary policy decisions to work their way through the economy. As an example of the aftereffects, if you owe the bank money and rates start to increase, the amount of money you must repay the bank also increases. A small increase will infer that your household or business will have to spend more to service the debt than the month before, hence less will be available to save or spend. If the increase in payment is relatively small the household or business should be able to absorb this.
However, increase the rates and the cost of servicing the debt at a pace never seen before and the possibility of not being able to service the debt increases in line. Fourteen odd months ago the bottom end of the Fed Funds Rate was 0.25%; today it is standing at 5%, theoretically speaking a 2 000% increase.
As the saying goes, “What can go wrong?”
Quite a lot.
In the US, once again depending on the source referenced, most home loans have a fixed rate with a period ranging up to 30 years. There is a high probability that if you took out a fixed-rate loan, your monthly payments have stayed the same as rates have increased over a relatively short period of time. Good for you. But what happens when your fixed-rate period ends and the rate on your home adjusts? For the sake of the thought experiment, imagine your down payment on your home loan increases from one month to the next by 2 000%! An instant increase, not a gradual one.
As a caveat, we do not know what the home loan contracts and terms and conditions look like for the 4 200 commercial banks in the US. But the principle still holds: if one of your biggest payments out of your monthly budget increases by a considerable amount, you could be in trouble if you need to refinance. (And if you are a home buyer for the first time, it is now considerably more difficult to afford a home.) A Bankrate Emergency Fund report, published in February this year, reported that 57% of US adults are currently not able to afford a $1 000 emergency expense.
The consequences of the truly unprecedented interest rate increases seen over the past 17 odd months are impossible to predict, consequences which could be unprecedented. But truly no-one knows. On the Federal Reserve website, the organisation states, “The Federal Reserve Board employs just over 400 PhD economists, who represent an exceptionally diverse range of interests and specific areas of expertise.” Last update: 10 August, 2022. If you consider that the Federal Reserve, on a regular basis, misinterprets the economy and thefuture consequences of their actions, predictions should rather be ignored.
The 2010s were a great period for stocks. Put another way, Goldilocks was in the House. There were low interest rates and low inflation. Money was cheap, basically free. And since returns on bonds and income-based investments were low, investors turned to the stock market. Those were the days it now seems. Will we return to those days? Will inflation roll over, interest rates be cut as we come in for a soft landing on the Hudson River? Can we once again invite Goldilocks in for some porridge after she has wandered off for a while? I do not know, no-one does, but this is not a portfolio management strategy.
The probability of Goldilocks returning and staying for lunch and dinner after breakfast is low. Here is why…
If you have given out free money for a decade, ie it cost you very little to service your debt, and possibly you have increased your debt as it didn’t cost you much, it would be foolish to think a 2 000% increase in the interest rate will not affect you. When money is free, people do foolish things.
It took the Federal Reserve 17 months to hike the rate to the current range of 5% and 5.25%. If we assume the Fed panics after a hard landing and the rate retreats in let’s assume eight months to 2.50% and 2.75%, that will still infer that the rate is higher by roughly 1 000% than what it was almost two years ago, and you have much more debt. Salaries have increased, absolutely, but not by the same measure as the interest rate.
In addition, if individuals and companies need to spend more on servicing their debt, they have less to spend on other things like iPhones and increasing production capacity. If less is spent, less is consumed and this is not advantageous for the economy, in the US or anywhere else. So, should we pack our bags and run for the proverbial hills? In short, no. Because we do not know how this will play out. But to construct a resilient portfolio we need to practice caution. “You want to be structured to participate in the march of mankind but to survive the dips along the way.” – Matthew McLennan
What Mr McLennan is referring to is a general investment and portfolio management principle that we all should adhere to, always, not only when there are dark clouds on the horizon that might, or might not, bring a heavy storm. To just invest and forget is a beautiful, mathematically proven strategy, taught in Investment Management 101, but often ignored in Human Management 301. Homo sapiens
are risk averse and if the probability of sticking to a longterm investment plan is reduced to the point of failure by unexpected market conditions you need to re-think your portfolio. You need to construct a portfolio that can survive the dips along the way.
Bond giant Pimco has an idea called “strategic mediocrity”: “You’re never the best in the short run, but you stick around long enough to outlive the competition and come out on top.” While Pimco is referring to competition, you can substitute this with the objective of your portfolio or that of the client, company or pension fund you are managing. Never invest in such a way that you are carried out when those clouds bring a hailstorm!
Many a market commentator is professing that we should be ready as there will be volatility over the short term. They are however stating the obvious as there is always volatility over the short term. This is the nature of markets. Client portfolios should be “ready” in that short term liabilities should be able to be met with low risk, cash and income like investments that are little rattled by stock market movements. This will help your clients to survive a possible dip along the way. Long-term investments in turn should still be invested to participate in the
march of mankind.