Investors are obsessed over predicting the timing of the Fed's first interest
rate hike. Will it raise the Fed Funds rate in September, or wait until next
year? But it is far more important to get a grasp on the pace of rate hikes.
Will it be a one and done move, or does this mark the beginning of an incremental
tightening cycle? Those of us who are not in the inner circle are forced to
only speculate.
But one thing is certain: If history is any guide, whatever they do the Fed
will get it wrong. Most market commentators place unfounded belief in the Fed's
acumen. But the truth is: I wouldn't trust the Fed to tell me what the weather
is going to do in the next 30 seconds--even if they were looking out the window.
Once you understand the nature of bubbles -- how they are created and how
they burst -- you can be assured this latest manifestation will also end in
disaster. If the Fed raises rates in the manner in which the dot plots currently
suggest it will quickly burst the bubbles already created in the real estate,
stock and bond markets. On the other hand, if the Fed opts to only make a small
token move higher in the cost of money it will allow asset bubbles to spin
out of control until inflation destroys the vestiges of economic growth.
Our Central Bank has been deluding itself into believing it can easily escape
from its nearly $4 trillion expansion of the monetary base and 7 years of virtually
free money. But that is a spurious belief. Bubbles never die slowly and always
bring about dire consequences. The bigger the bubbles the worse the backlash--and
never before in the history of economics have central banks distorted market
prices to this extent.
All bubbles share the conditions of the asset being overpriced, over-supplied
and over-owned when compared to historical norms. And all bubbles are built
on a massive increase in debt. For examples; the Tech Bubble was fueled by
a rapid increase of margin interest, and the housing bubble was fueled by the
ownership of properties with little to no equity. Bubbles always sit atop a
humongous pile of borrowed money. Today we have a tremendous amount of margin
and leverage in both equities and fixed income assets.
For example, we see in this chart from the NYX data website that the percentage
growth rate of margin debt vastly outstripped S&P 500 returns in real terms
just prior to the collapses of 2000 and 2008.
Continued debt accumulation only makes sense if the underlying asset is increasing
in price. Once the principal of the asset stops rising, there is a massive
unwinding of leverage, which causes the asset in question to plummet in value.
Why do asset prices stop increasing in price? Because the spigot for new credit
gets turned off once the cost of borrowing funds becomes unprofitable for banks
and/or consumers.
This is why true bubbles always bust in violent fashion. Overleveraged buyers
are forced to panic out of the investment as soon as its price plateaus. And
that panic selling begets more selling until there is a total washout of leveraged
ownership; that is, until prices can be supported easily by highly-liquid investors.
However, the Fed wants investors to believe it can raise interest rates at
the absolute perfect pace that will not deflate the bubbles in equities, real
estate and all fixed income classes. But this a just a sophomoric and quixotic
fantasy.
If the Fed raises rates expediently (in other words, gets ahead of the inflation
rate in short period of time) the yield curve will flatten out more quickly
than in past tightening cycles. This is because the spread between the Fed
Funds rate and the belly of the yield curve is currently at a historically
low starting point.
And importantly, the Fed won't be raising rates into an environment of robust
inflation, as in the norm: instead, it will be raising rates just because it
has become exceedingly uncomfortable being at the zero bound range for so many
years. Once the yield curve flattens or inverts, money supply growth will get
chocked off and asset prices will tumble into a deflationary death spiral similar
to what occurred in 2008. This is exactly what will occur--after she begins
liftoff from ZIRP -- if Ms. Yellen doesn't convince the market that she has
fully repudiated the Fed's current dot plot model, which has the F.F. Rate
at 1.625% by the end of 2016.
On the other hand, if the Fed stays at zero, or does a token one-and-done
move on rates, asset prices could become even more grossly distorted in the
immediate future. Then, after several more quarters of free money and asset
bubble growth, the rate of inflation will begin to pick up serious momentum
-- especially since the rise in the dollar on the DXY from 80, to 100 during
the past year will quickly unravel.
In this case, pressure building up on long-term rates should explode in a
sudden and violent manner. Rates will soar not because the Fed is increasing
short-term rates but precisely because the free market will awaken to the idea
that our central bank has, at least temporarily, caused inflation to become
intractable.
The Fed's "success" with creating inflation and the concomitant spike in long-term
interest rates will, by definition, pop the fixed-income bubble, which will
then cause a pernicious collapse in real estate, most equities and the economy
as a whole. There shouldn't be any doubt that spiking long-term rates will
become the bane for the additional $8 trillion increase in non-financial debt
piled onto the U.S. economy since 2008.
Our view at Pento Portfolio Strategies is that the Fed will take the latter
approach and cause the rate of inflation to grow at dangerous and intractable
pace. But a prudent investor needs to be prepared for either scenario because
the slope of the central bank's increase in the Fed Funds Rate will be crucial
in determining the outcome. And the investment course will be vastly different
for each situation. Most importantly, it is essential to be aware that an unprecedented
period of market and economic turmoil lies just ahead. The good news is having
the proper preparation and strategy will enable investors to profit from it.
