The Fed Does It Again
The December FOMC meeting approved another rise in the basic overnight rate, which is now 1.25% – 1.50%. Three more rate hikes are planned for 2018, which would bring the base rate to 2.00% – 2.25%. Market observers have noted that in the past almost every time the Fed starts a round of interest rate hikes an economic downturn followed because of the higher cost of credit. In this case the intention of the Fed to reduce its balance by US $ 10 billion monthly and then to increase the pace of reductions should lead to even tighter credit as the balance reduction process continues.
The stock markets do not seem to have taken notice of this development while US inflation as reckoned by the CPI is still under 2%. The ECB is staying on course and apparently has no intention of raising interest rates any time soon as inflation is still below the much-heralded threshold of 2%. With the US stock markets highly overvalued and the Fed apparently intending to reduce its balance and raise interest rates, money managers will be scrambling to prepare for downturns in stock prices and to examine a reallocation of resources in portfolios. The bond managers who seemed to be near-geniuses because of the great increase in the value of bond portfolios that resulted from the drastic measures employed by central banks to counter the crisis of 2008, namely, a low-interest rate policy that dragged on for years, are going to suffer heavy losses in bond portfolios as the interest rates increase.
Investors should be examining exit strategies for stocks and evaluating new bond issues. The problem is that the issue price will be higher than the price on the secondary market as soon as the Fed announces the next interest rate increase. It is only to be expected that bond managers will price in three more rate hikes of 0.25% for 2018. One could also see a widening spread between interest rates for bond issues that are not really good investment grade paper as compared with AAA and AA.
As the Fed continues with its announced policy of raising rates, it will be easier to find good buys in the secondary market as earlier issues will have lower prices in order to reflect the higher interest rates of new issues. Bond bargain hunters will be busy at work. At the same time pension funds that are locked into long-term bonds at extremely low interest rates are going to have to explain why they had to make bad investments. This Newsletter repeatedly warned against investing in bonds with very low interest rates. The day of reckoning for the bond market is drawing nigh just as the next recession is not far off. 2018 is going to be an interesting year.
Walter Snyder
info@swissfinancialconsulting.ch
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