Rate Hike: How Will the Markets Respond Next Week?

Harry_headshot-150x150First of all, I think we’re all a little sick of hearing whether the Fed will raise rates this month – or whether they should’ve done it sooner. We’re talking about 0.25% if they do it!

After seven years of zero interest rate policies, economists should be much more worried about the damage done from speculative bubbles and mal-investments created from such rates.

But the reason the markets could have a larger response to a hike is that they’re not used to a one-and-done, which is what I see happening.

Instead, they’ve witnessed the Fed going in one direction or the other for significant periods of time. So they assume that once they start hiking, they’ll continue to do so for years, even if very slowly.

But I don’t see that happening here.

If the Fed finally does raise rates, a whopping 0.25%, I predict that will be the last rate hike for a long time. And with worsening demographic trends here and around the world (especially in Europe), I don’t see much of a debate on the matter.

Just think – Japan’s fallen back into recession after the strongest QE ever.

Meanwhile, Europe is languishing, China and emerging countries continue to slow, and retail sales are weakening in the U.S.

Top it off with escalating geopolitical events and tensions – even a possible stock correction just ahead – and there’s a chance the Fed may hold off at the last minute.

But for now, the markets are largely convinced a hike will happen…

So let’s just cover our bases: what will that look like if it occurs?

For starters, I think stocks would react favorably just a little, but only at first. In the short-term, it would be a sign that the Fed felt confident in the economy enough to finally raise rates.

And for bonds, it would only be a negative for prices as yields would naturally start inching up.

But that’s just the beginning…

At some point, now very likely in 2016, we will have another financial crisis that will send the yields on riskier bonds soaring exponentially.

We could even see an initial, smaller spike in longer-term Treasury bonds. But before you know it, those yields will head down, and prices up, as Treasurys become the safe haven again.

That’s just what happened in late 2008. But let’s look more closely at a much more extreme example that came from 1932 to 1940.

In late 1931 when the Fed was faced with growing deficits, they decided to hike short-term rates big time – from 0.6%, all the way to 3.3%, which we now look back on as a huge mistake.

At first, long-term Treasury yields bounced from 3.2% to 4.2%. But then, it switched, and eventually yields fell from early 1932 into late 1941 to as low as 1.8%.

And if that sounds bad, corporate bonds reacted much more extremely. Take a look:

Chart 8.4 Great Depression AheadDuring this time, the highest quality Aaa bonds spiked from 4.2% to 5.7% into mid-1932 as stocks bottomed. (Note the yields here are inverted, with rising rates pointing downward, to reflect lower bonds prices and a growing financial crisis.)

Next in line, Aa bonds rose from 4.7% to 6.9%…

A bonds from 5.8% to 9.0%…

And the lower grade Baa bonds from 7.0% to 13.0%!

Now, I don’t expect our much more accommodative Fed of today to react like this – not in an economy that’s been weak for seven years after a crisis.

This is just meant to illustrate that yields spike in the short-term when the markets figure out everything’s crashing!

But I do still see a spike ahead – just one that comes from a worsening economy and higher default rates.

Which is why I could care less about miniscule Fed rate hikes, and am a lot more concerned about economic weakness.

I do see a short-term spike happening in 10- and 30-year Treasurys as I told Boom & Bust readers in November. But I don’t expect it to last for long – especially when deflationary trends become more obvious. Higher risk bonds, however, I expect will rise in rates and plummet in value for years.

Ultimately, deflation in the years ahead will bode well for the highest-quality bonds, and poorly for the lower-quality ones. Just look at junk bonds, which are down nearly 20% from their highs!

That’s why I advise you get out of higher-risk bonds sooner rather than later.

But don’t load up on longer-term Treasurys just yet.

Boom & Bust readers will be the first to know the right moment to strike.


Harry

Follow me on Twitter @harrydentjr

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Categories: Interest Rates

About Author

Harry studied economics in college in the ’70s, but found it vague and inconclusive. He became so disillusioned by the state of the profession that he turned his back on it. Instead, he threw himself into the burgeoning New Science of Finance, which married economic research and market research and encompassed identifying and studying demographic trends, business cycles, consumers’ purchasing power and many, many other trends that empowered him to forecast economic and market changes.