Could a FED Rate Increase Actually Reduce Long Term Rates?

In a word, yes.

Why you should care:   Notwithstanding my arguments to the contrary, there is a chance the FED will increase 25 basis points in mid-June.

A rate increase will have immediate effect on things like short-term indices (LIBOR, Prime, etc).  So if your home loan is tied to a variable index, your rate will increase.  Banks might start paying a bit more interest…but we’ll see.

The biggest impact may be felt in the stock and bond markets, as well as the foreign exchange markets.    Stocks that are interest-rate sensitive are likely to move inversely.   As will bonds – the longer the maturity, the bigger the effect.

The big wild card is what affect this move might have on the value of the dollar against other currencies.   And this has a lot of implications.

Taking action:   Again, you’ll have to decide – before June 15th – if you feel the FED will move…and if they do, how the move will affect you.   Remember, the FEDs decision is highly data dependent.  A lot can – and will – happen in the next two weeks.  We will be watching closely.

THE BLOG:   Look, let’s face facts:   Notwithstanding my belief that a rate increase is ill advised at present, I have yet to receive a phone call from the FED asking for my opinion.   Yes, I’m sure you’re as shocked as I!

And so we have to follow the data…as we’ve been doing.  And the data isn’t awful.  It’s not robust…but it’s OK…lukewarm.

I balance these facts against the backdrop of the current conditions in developed nations.  They are not good:  The UK ‘Brexit’ vote on June 26; near zero growth and inflation in the entire EU; and, Japan still fighting with deflationary pressures, almost no GDP growth, and sovereign debt of almost 2.5X their annual GDP.

And I balance it against the likely and immediate results of a rate hike:  An increase in the US Dollar index.   While the economies of other developed nations languished, after threatening for many months, the FED tightened on December 16, 2015.   And they indicated this the the first of 3 or more hikes to follow.

The FEDs commentary drives perception…and the perception was US short-term interest rates were moving up.   During the last 1/2 of 2015, here’s what happened to the ‘Trade Weighted Dollar Index’:

The TWDI experienced an almost 11% increase.   Which means that during 2015, all US exports of goods and services became more expensive overseas, and all foreign imports became cheaper for us.

Exports increase our GDP.   Imports have the opposite effect.  Thus, a rate increase now will most likely reduce future US GDP.

It will also make our government debt more attractive to foreign buyers.  Remember, at present most foreign bondholders are getting near zero – or negative – interest on their investments.   As the interest rate disparity grows, so will US government debt popularity.   Our longer term debt instruments could very well see significant further rate reductions as more buyers enter the fray.  This is merely a continuation of what began in mid-2013:

Compared to the rest of the developed world, our interest rates are quite high.   In a world seeking yield, it’s likely our long-term Treasury debt products will grow in popularity, and long term rates will decline as a result.

Lots to consider.

• Terry Liebman