The Big Picture
“Which came first? The chicken or the egg?”
The chicken or the egg is a causality dilemma which asks the simple question of “which came first?” It is a rather amusing dilemma. Aristotle hypothesized that it was an infinite sequence and neither came first. That is a clever way to dodge the problem. It must have drove him crazy so he concluded there was no beginning!
Are there situations where it is not clear which event is the cause and which is the effect? There absolutely are. And one widely debated in the economic world is whether the Federal Reserve (The Fed) causes recessions by raising interest rates or whether they are always behind the curve and raise too late into an already dwindling economic cycle.
Have a Plan and a Process!
From the Trenches
“I just ordered a chicken and an egg, to see which one comes first… I’ll keep you posted!“
It has been 3 years since the first increase in interest rates by the Fed during this cycle. They have raises rates 8 times since 2015. From my last post which discussed some differences between this cycle and a “normal cycle”, there is now an additional argument on the Fed’s agenda. The debates generally sound like this:
- The Fed’s raising of interest rates slows the economy by raising borrowing costs and ultimately causes a recession! Home-builders love this one. It gives them an “easy out”. There is truth to rising borrowing costs stifling home sales. Anything that is purchased with debt is of course affected by higher rates.
- The Fed was late to the game in raising interest rates and the economy overheated, now they are trying to catch up. This was a common argument after the Dot-Com bubble in 2000. The economy overheated especially in the technology and internet sector, the Fed may have been slow to react, and ultimately a bubble ensued. Tragically the Fed then may have eased too much which enabled the real estate bubble to begin. Back to back policy mistakes? There is a strong cohort of investment professionals that strongly believe the Fed is responsible for these Bubbles! This is a thesis worth further due diligence.
- A new discussion: The Fed is shooting blanks and they have no further tools to combat an economic slowdown!This has been discussed for several years and likely has plenty of merit. The Fed is plausibly quite concerned about this.
The Fed’s economic models are observed to be very reactionary in nature. They follow a very linear model on assessing the economy and the markets which relies much more on past events than probabilities on the future. There have been several studies on the various tools they utilize and much is left to be desired. The Fed Model – which is in their own namesake and attempts to determine if the stock market is fairly valued based on where the 10 year treasury rate lies, has been broadly determined to “not work very well.” Unfortunately, that is not humor…
Bottom line: Rising interest rates are a sign that the Fed believes the economy is healthy, and that the Fed is more concerned about inflation than stifling economic growth. Only time will tell whether these actions are warranted.
“Interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.” -Warren Buffett
Who else? Another bulls-eye remark from the Oracle…
It has been an ugly few days in the markets to say the least. It is quite frustrating when all asset classes are declining. However this happens from time to time. The traditional belief that stocks and bonds will move counter to each other will be challenged going forward. More to come on this topic! The catalyst for this move likely revolved around the move in interest rates as well as continued Global concerns. That said, the actual trigger that causes the decline never really matters! What occurs is a catalyst is brewing for some time then the event tends to happen in an instant! And we have an ugly sell-everything day. As Mr. Buffet points out in the above quote interest rates have a “gravitational pull” on asset prices. The higher rates go, the lower we should expect stock prices as well as real estate prices to go.
A quick side note regarding Global concerns: There has been much worry over trade wars and tariffs, etc. Have you noticed that much of the international community are already in bear markets? China, much of Europe, South America, are already reflecting the slowdown. We have been recommending avoiding or at minimum under-weighting International for some time now.
So what is the Fed’s take on the markets at present?
No way to know for sure what happens behind closed doors. As the Fed continues to raise interest rates a transition of expectations occurs. The initial increases are viewed as a positive as the recognition that the economy is growing again and can “stand on its own feet” makes investors more positive on the markets. However, as Fed policy continues to tighten (i.e. raising interest rates) investors become concerned that the market cycle is getting late and the Fed is trying to slow the economy as well as the markets down. This is likely the reaction we are currently witnessing.