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Betting on Low Interest

When will the Fed raise interest rates? If you ask investors, the answer is “Not this year”. Bets have been placed on bond futures which imply that the Fed Funds Rate will be no higher than a quarter of a percent at the end of the year – hardly any rise at all.

But if you ask the Fed, it’s going to come soon. Why doesn’t anyone believe them?

Better than cheese, at least to the investment savvy mouse.

Better than cheese, at least to the investment savvy mouse.

We’re still in the regime of the “liquidity trap” where economic stimulus simply doesn’t happen at lower rates because there’s already too much cash out there. More doesn’t do a thing except concentrate in the hands of those who already have a lot.

This doesn’t mean that there aren’t other effects which drive the economy, however. Chief among these is the foreign exchange rate, or the value of the US Dollar beyond our borders. A stronger US Dollar makes our goods more expensive when the price is converted to Euros, Reals, Yuan, or Yen. Manufacturers start sourcing more parts away from the US, where everything seems cheaper by comparison.

A higher interest rate makes Dollars harder to get, which raises their value. The strong run in the Dollar through 2014 resulted in the Euro falling an amazing 22% versus the greenback over a one year period:

US Dollars per Euro.  Chart by the St Louis Fed.

US Dollars per Euro. Chart by the St Louis Fed.

Everything we sell to Europe jumped in price by 22% during this period. And since oil is priced in US Dollars, a good part of the collapse in oil prices in $/bbl was about the strength of the Dollar as much as the weakness of oil.

Not everyone can do this.

Not everyone can do this.

But the Fed hasn’t raised rates yet, and the US Dollar isn’t harder to get. The world is awash in our paper. So what’s driving the increase?

The short answer is nothing. This is shown by a collapse in the value of the buck that came very suddenly on the back end of a very weak retail sales report for April. There was no net increase at all in retail sales, a bit lower than the expected weak 0.2%. It was nothing but the straw that broke the camel’s back, causing a massive sell-off of the Dollar and general speculation that the Fed isn’t going to raise rates in the near future.

What’s funny about this is that the Fed has made their intentions pretty clear. David Altig, research head at the Federal Reserve Bank of Atlanta, said, a rise “feels most probable somewhere in the late summer than the early summer, but early summer is not out of the question.” How big? “Even after we move, we don’t expect to move all that quickly. We’re going to be data dependent.”

Go ahead, take us on!

Go ahead, take us on!

That probably means a small, token rise – but it’s a rise all the same. No matter what the market says, the Fed is definitely interested in raising rates.

Why on earth would anyone bet against the Fed?

The short answer is the market believes it knows better what is coming and the Fed isn’t going to do a thing this summer. This should keep the US Dollar on a downward trajectory against the Euro and, gradually, raise oil prices. That may have the effect of cooling off the economy more than any rise in interest rates, too. It also might employ more people as manufacturing gets a break and the oil industry starts to drill new wells again.

The delicate balance that has to be kept is largely outside of the Fed’s control no matter what. Why do we care what interest rates are, then?

Oh, yes. The rest of us have to pay interest on the money we borrow from banks. Low rates benefit everyone as long as inflation remains low, and in an economy that still needs more work the Fed is going to do its best to keep the stimulus coming. The problem, however, is that it is losing a little more control every day – and the market is now betting that it has more power than the Fed.

Who will win? We’ll find out this summer, if the rhetoric from the Fed is accurate.

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13 thoughts on “Betting on Low Interest

  1. It seems to me, companies need to hire more workers, and/or pay the workers they have more money. Gets the money out there circulating rather than sitting being hoarded by people that already have tons of it, the money is being put to work expanding the economy, and maybe we’ll have a little bit of inflation…which, despite an almost pathological fear of by our corporate-run government, is probably a good thing. Then a rise in interest rates will actually help keep that inflation in check.

    • This is what the Fed wanted all along, and since they can only influence money supply it was their contribution to ending the Depression. The missing piece is, indeed, that the money is not getting out into the world and doing good things like creating work, etc. A little inflation would indeed be a good thing because it would put pressure on everyone sitting on the money to spend it. But the plan just isn’t working.
      That’s basically what we call a “liquidity trap” in a nutshell. There is liquidity, but there is too much of it.

    • I wouldn’t say crash, but there will be pain. I do see a quarter point early in the summer and maybe another quarter later on – and that might be it for now. But when it happens there could well be a panic given how much is bet against it happening. And the word “bet” is indeed the right word.

  2. If they did raise rates I’ll bet nothing really happens. Availability of credit has a lot more to do with credit ratings these days. Finding a loan is the hard part & consumers are paying a lot more for mortgages than they used to anyways because they have to take what they can get.

  3. Be careful what you wish for with inflation. If it takes off it will be unstoppable with all this cash on the sidelines.

    • If all this money went out into the economy at once, you are right. The trick is to have a gradual turnaround, which is what we’re hoping for. Stagflation would be unbearable right now, yes.

  4. The US dollar is in a strange position. There is far too much of it around, thanks to quantitative easing, BUT the velocity of it is low because a lot of it is being sat on. China is one example. The problem arises if those sitting on it decide to become more active with it. Their problem is, they lose too, but sitting on it is merely an interest-free loan to the Fed. My guess is that any prediction of the future is likely to be wrong because there rare too many things that could happen and nobody has a clue as to the mindsets of the few who pull the triggers.

    • Absolutely. If that idle money goes out slowly, which is to say velocity increases slowly, all should be good. But if it starts moving rapidly for whatever reason there will be inflation. Currently, velocity (I favor MZM) is if anything still going down. But it’s a crapshoot.

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