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How high can federal interest rates go?

While most sports fans were watching the Final Four basketball tournament last weekend or preparing to watch the Masters golf tournament this weekend, those of us in the investment game are engaged in an entirely different armchair pastime. It’s called Fed watching.

As in regular sports, it is not enough to merely sit back and watch the action. The fun - and profits - lie in guessing the outcome before it happens. By the time the final putt drops at the Masters, the betting windows in Las Vegas are closed and there is nothing to be done about it.

Likewise with the interest-rate actions of the Federal Reserve Board. In the days and weeks leading up to a policy meeting, everyone in the financial markets has an opinion. Are rates going up, down or staying flat?

That’s part of the guessing-game, but it’s not enough to make it really exciting. It’s like the point spread in football. Picking the winner doesn’t make you money; picking the point spread is where the action is. When a first-place team plays a last-place team, it doesn’t take a sports genius to pick the probable winner. The skill and the profit opportunity lie in correctly guessing the margin of victory.

In the Fed-watching game, we sometimes know with near certainty just what the Fed is going to do. The market anticipates a pending rate change and that change is reflected in securities prices weeks in advance. When the actual rate change happens as expected, the stock and bond markets just yawn and go about their business.

In the short-run, the Fed rarely hits us with a major surprise in the level and amount of actual interest rate changes. The devil, as they say, is in the details. The Fed doesn’t merely raise or lower rates, it also releases a short statement saying just why it took the action.

Since I am an asset manager, not a trader, I don’t much worry about making money from a single month’s Fed action. I am more concerned with the general trends and what the Fed is going to do on a cumulative basis over time. One rate increase of a quarter of a percent means almost nothing to me. String eight or 10 or 20 of those together in a row, now we’re looking at something interesting.

It is not the level of interest rates that drives securities prices, it is the journey from one level to another. As rates move from high to low, or from low to high, the stock and bond markets and the economy will react in predictable ways.

The questions I care most about are: How high will the Fed go, and when will they stop? Rather than spend my energy trying to guess the outcome of each Fed board meeting, I want to be prepared for the effect that Fed action will have on the economy as a whole, over time.

At its meeting last week, the Fed said that it sees “potential to add to inflationary pressures.” The economy rebounded in the first quarter after stuttering in the fourth. Housing sales are cooling, but widespread price declines are not in evidence. Consumers remain on a spending spree. The national savings rate remains decidedly negative.

This cannot go on for long, for obvious reasons. One way to turn these trends around is to keep raising rates.

The Fed has a long and glorious history of not stopping a rate-raising cycle until the economy really and truly sputters badly. The Fed remains worried about inflation, and they do not yet see any evidence that the rate hikes over the past two years have done the slightest damage to the economy. So far, the economy and the investment markets have shrugged off these rate increases.

They will not do so forever. It is my view that the Fed will go on raising rates until asset prices and economic activity go through a pronounced downturn. In fact, if the Fed stopped raising rates today, the investment markets would overheat to an explosive level.

I don’t think the turning point is too far away. The Fed could very well be lowering rates once again within the year.

Write to Rick Ashburn at rick@richardashburn.com.