Are You Ready? The FED Says More Tightening Ahead

May 29, 2017

Are You Ready? The FED Says More Tightening Ahead

  • The FED’s meeting minutes clearly signal more tightening ahead.
  • Inflation has consistently been above 2% in 2017, so we can say “bye bye” to low interest rates.
  • There’s a rosy scenario for the economy and a negative one. In both, stocks are bound to fall.

Introduction

Inflation is an extremely important factor concerning anything related to investing. Over time, there’s a huge difference between real (inflation adjusted) and nominal returns. Therefore, we always have to keep an eye on inflation and invest accordingly to minimize the risk of seeing inflation eat up our returns, and to maximize our real returns.

Current Inflation

The inflation rate in the U.S. has consistently been above 2% in 2017.


Figure 1: U.S. inflation rate. Source: Trading Economics.

Inflation above 2% is crucial. Inflation below 2% was the factor that allowed the FED to hold off-monetary policy tightening for a long time. A longer period with low interest rates boosted economic growth. As inflation rises, the FED doesn’t have any more maneuvering space and has to increase interest rates to prevent hyperinflation.

The latest FED meeting minutes signal that the FED will raise interest rates again pretty soon and that they will start to slowly unwind their huge balance sheet. The most important factor behind such a change in tone is inflation.

Will The FED’s Experiment Work Out Well?

The day of reckoning is getting closer. As the FED increases tightening, we are going to see whether the experiment of an economy with low interest rates and extreme liquidity will prove itself as a good long term bet. The FED’s long term target is clear, to have inflation at 2% and interest rates at 3%. This will be achieved by further interest rate increases and by not reinvesting the maturing bonds on the FED’s balance sheet.

If the FED manages to slowly tighten, keep inflation under control, unemployment low, and the economy continues to grow, it will be an amazing result. However, the result won’t be so amazing for investors. If the FED raises interest rates to 3%, the yield on U.S. treasuries will increase and the required return from stocks will also increase.

For now, the FED has increased rates a bit, treasury yields have also increased a bit, but the required return from stocks still hasn’t increased. Such a divergence is a result of the high liquidity that allows for a high inflow of funds into the stock market and expected abnormal economic growth. However, sooner or later, the expected returns from stocks will adjust.


Figure 2: A higher federal funds rate leads to higher treasury yields. Source: FRED.

Despite the fact that both the federal funds rate and the treasury yield increased, the earnings yield from stocks continued to decline.


Figure 3: S&P 500 earnings yield. Source: Mulpl.

You’d expect the required earnings yield from stocks to increase, but temporary divergences are normal. In the long-term, all indicators will align properly.

What can we expect? Well, if the FED’s scenario materializes, we can expect the federal funds rate at 3%, the 10-year treasury at 4.5% given the current spread, and the expected yield from stocks to be at least around 6% if not higher.

As most managers are focused only on buybacks and higher stock prices, I wouldn’t expect S&P 500 earnings to increase by much in the future. This means that the S&P 500 should fall to 1,600 points in order to yield at least 6%. This is the FED’s best case scenario.

The FED is very open about its intentions, but nobody seems to listen. Be smart and listen now to save yourself from the inevitable decline of the S&P 500. This is in case all evolves as planned.

The Negative Scenario

In a negative scenario, the FED won’t be able to increase rates due to some kind of economic slowdown. A new quantitative easing program would completely discredit the dollar, inflation would skyrocket while the economy would enter into a recession. All the things we have been taking for granted in the last 8 years would fall apart and stocks would tumble even lower than the 1,600-point level described above. I hope such a scenario doesn’t materialize but just in case, I have a 30-year fixed interest mortgage on my house with an historically low interest rate and a small but significant chunk of my portfolio exposed to commodities, including gold.

Conclusion 

Did I forget to talk about a scenario where stocks go up? Perhaps stocks will go up in the short term due to the still abundant liquidity and low interest rates, but both a rosy economic scenario and a negative one will be detrimental for stocks. Corporate management hasn’t invested in organic growth in the last 5 years as they were instead only thinking about taking on as much debt as possible to increase dividends and buybacks, so we can’t expect higher earnings to offset higher interest rates, especially if inflation pushes costs up while the competition keeps the revenues stable.