Why It Matters If The Fed Raises Rates

628x471This summer might prove to be quite rocky for the American and global economies. The smart money is on the Federal Reserve raising its borrowing rate from a paltry 0.25% to something…marginally less paltry. But in a world where borrowing rates are already incredibly low even a modest increase has some investors shaking in their boots.

Why is this? And why do interest rates matter so much? And why should a small increase in the government borrowing rate matter so greatly? The answer has everything to do with that financial black hole 2008.

I asked NASA to use the Hubble telescope to take a photo of the 2008 financial crash. This is what it looks like from space.
I asked NASA to use the Hubble telescope to take a photo of the 2008 financial crash. This is what it looks like from space.

No matter how much time passes we still seem to orbit that particular mess. In this instance it is America’s relative success in returning economic strength that is the source of the woes. Following the crash their was a great deal of “slack” in the economy. Essentially factories that didn’t run, houses that sat empty and office space that was unused. The problem in a recession is convincing 1. Banks to lend to people to start or expand businesses, and 2. to convince people to borrow. During the great depression the double hit of banks raising lending rates and people being unable to borrow created a protracted problem, and it was the mission of the Federal Reserve in 2008 to not let that happen again.
US GDP Growth 2012-2015 source: tradingeconomics.com

To do that the American government stepped in, first with bailouts to pick up the bad debt (cleaning the slate so to speak) and then with a two pronged attack, by lowering the overnight lending rate (the rate that banks can borrow at) and then promising to buy bonds indefinitely, (called Quantitative Easing). The effect is to print mountains of money, but in ways that should hopefully stimulate banks and corporations to lend and spend on new projects. But such a program can’t go on for ever. Backing this enormous expansions of the treasury requires borrowing from other people (primarily China) and the very reasonable fear is that if this goes on too long either a new financial bubble will be created, or the dollar will become worthless (or both!).

Today the Fed is trying to determine whether that time has come. And yet that answer seems far from clear. Investors are wary that the economy can survive without the crutch of cheap credit. Analysts and economists are nervous that raising rates will push the US dollar higher, making it less competitive globally. Meanwhile other countries are dropping interest rates. Germany issued a negative bond. Canada’s own key lending rates was cut earlier this year. People are rightly worried that a move to tighten lending is going in the exact opposite direction of global trends of deflation. If anything, some argue the US needs more credit.

The question of raising rates reveals just how little we really know about the financial seas that we are sailing. I often like to point to Japan, whose own economic problems are both vast and mysterious. Lots of research has gone into trying to both account for Japan’s economic malaise; it’s high debt, non-existent inflation, and how to resolve it. Currently the Japanese government is making a serious and prolonged attempt to change the country’s twenty year funk, but it is meeting both high resistance and has no guarantee of success.

Similarly we have some guesses about what might happen if the Fed raises its rates in the summer or fall. Most of the predictions are temporary instability, but generally the trend is good, raising rates usually correlates to a stronger and more profitable market.

But that’s the key word. Usually. Usually European countries aren’t issuing negative interest rates on their debt. Usually we aren’t in quite a pronounced deflationary cycle. Usually we aren’t buying billions of dollars of bonds every month. Usually.

The answer isn’t to ignore the bad predictions, or obsess over them. The best idea is to review your portfolio and make sure it’s anti-fragile. That means incorporating traditional investment techniques and keeping a steadfast watch over the markets through what are often considered the quiet months of the year.

Only Time Gives Clarity to Investors

The reality of the 21st century is that finding clarity in world events for investors is almost impossible. Take the recent price drop in oil, which has been hailed as both a good and bad thing. And as the new lower price of energy slowly becomes the norm, everyday news reports come in about its respective benefits and unintended negative consequences.

https://twitter.com/Walker_Report/status/540161044786589698

Those seeking to know what those events mean and what guidance headlines should give will only be frustrated by the almost endless supply of information that seeks to empower decisions but leaves many scratching their heads in wonder about the future.

Screen Shot 2014-12-03 at 8.36.05 PM

A big reason for this is the sheer volume of information that we can now rely on. Since the advent of computers and the more recent rise of high-speed communication and networking we have found that the core truth of an event still isn’t apparent until after something has happened. In other words it’s almost impossible to predict corrections before they happen despite an almost inconceivable amount of data and endless ability to process it.

This is true no matter where we look in the world of investing. Consider Black Friday, the end all and be all day in shopping in the United States. This year Black Friday seemed to fizzle. Sales were down 11% year-over-year and that got people nervous. Yet Cyber Monday, the electronic version of Black Friday, sales were up 17% and topped $2 billion for the first time. Combined with the longer sales period leading up to the weekend, many suspect that total sales were actually higher.

All of this data conflicts with each other, which for investors means sometimes you will be wrong. Small things sometimes prove to be big things, and what initially appears simple turns out to be surprisingly complex, and much of it you simply won’t predict. This points investors back to some dull but surprising truths about investing.

1. Not much has changed when it comes to determining what makes a company worthwhile to invest in. Corporate health, sound governance and healthy cash flow still tell us more than loud hype about potential new markets, new products and new trends.

2. Time is a better arbiter than you about investing. The old line is time in the market, not timing the market, and that still appears true. Many Canadians are likely wringing their hands about the sudden drop of oil and the impact it is having on their portfolios. But the best course of action maybe not to abandon their investments, but make sure they are still sensibly invested and well diversified. The market still tends to correct in the long run and immediate volatility (both up and down) are smoothed out over time.

Screen Shot 2014-12-04 at 2.48.01 AM
The S&P 500 over the last 50 years. From Yahoo Finance

Not every sensible investment will work out, but a portfolio of sensible investments over time will. For investors now wondering about the future and their investments in Canada, the best thing to do is understand the logic behind their investments before choosing a course of action.