Weekly investment: Just in time for the down-cycle

Last week’s historic 25 basis point increase in the Fed Funds rate brings at least some clarity to the markets, although it ends the ‘zero interest rate’ policy era, bringing new uncertainties that investors will have to cope with.

“The cost of re-financings will be vastly increased”

Janet Yellen, an American economist, was at pains to emphasize that not too much should be made of the rate increase, as rates remain very low; however, the cost of a multitude of re-financings will be vastly increased from often ultra-low historic levels, and that is a considerable problem.

Writing in the FT, Jim Grant, the well-known market commentator said, “Exceptionally low borrowing costs pull consumption forward in time…and they push business failures backwards in time”. This puts it perfectly.

We, like others, have noted that keeping rates so close to zero for this long has distorted the workings of the financial system, yet the Fed has said there were growing dangers of leaving it longer to raise rates. In reality, history will probably judge that they had already left it two or three years too late to do so.

The Fed said its policy stance would remain ‘accommodative’ even after the increase, yet the reality is that the credit cycle has already turned downwards and that the direction of travel will be painful. We believe that even this ‘gradual’ tightening will be sufficient to tip the economy into recession. To be fair to the Fed and other central banks, through politicians’ policy failures they have arguably been asked to do too much.

The truth is that despite there being ‘room for further improvement in the labour market’, and inflation continuing to run below their longer-run objective, the Fed was nonetheless forced to move.

As they have stated, they need to have the flexibility to reduce rates in the event of a future shock to the economy.

By waiting so long, however, their ability to build a sufficient cushion during the next year or so will be very limited; because growth will in all likelihood be low, the rate at which the Fed can raise rates will be limited, and this has not been lost on the market, in which the yield on the 2-year Treasury Note is just below 1%.