Fed Raises Rates, Market Cuts Them

         The Federal Reserve raised the short term fed funds rate by 0.25% today. The Fed funds rate of 2.5% is higher than the 3 month T-Bills rate of 2.35%, thus inverting part of the yield curve. The 2 year Treasury yield inverted, becoming higher than the 5 year Treasury yield. The difference between the 2 year and 10 year Treasury are only 11 basis points, so they entire yield curve is moving towards inverting. The 30 year Treasury bond’s yield dropped below 3.0%. Stocks crashed hard making new lows for the year. Many stock market charts show technical trading indicators, such as trendlines and momentum, that have been broken, thus leading to a full stock market correction. A plunge in stock prices can help drive investors into bonds.

Rates dropped today by 4 basis points for the 10 year Treasury and a half basis point for the 2 year Treasury, thus the Fed’s rate increase sparked fear it would trigger a recession which would make rates go down.

Even if the Fed made short term bond yields rise this can actually help bond investors because a portfolio of short term bonds, during a period of rising rates, can produce a higher total return as a result of reinvestment of coupons and maturing bond proceeds into new, higher yielding bonds. However, this probably won’t happen because rates for the long end of the yield curve declined today. Assuming we are going into a recession then bond coupons (for those people that want to continue to be in bonds) will be reinvested into new, lower yielding bonds! Ultimately a bond investor should consider buying stocks once they become available at truly fair, low prices, which implies at least half off from the all-time highs. In the case of FANG type stocks they may repeat the Nasdaq crash of 2001 or the Nifty Fifty crash of 1974 where they dropped 75%. In the case of the Nifty Fifty crash the damage from inflation of the 1970’s meant the true inflation-adjusted loss was about an 88% decline. If you are going to lose 75% in tech stocks then why not buy a bond that pays 3%?
The Fed intends to keep selling off its holding of bonds (the Quantitative Tightening policy of reversing QE) which will act to raise interest rates. However, this may merely raise rates by a token 8 or 12 basis points a year, which will be overwhelmed by the coming recession that will drag down rates. They will also be overwhelmed by the gravitational tug of negative interest rates in Germany and Japan. It’s truly amazing that Germany and Japan have low unemployment, negative interest rates and yet, in theory they will have to cut interest rates in the next recession. How can they go from negative 0.3% to negative 5%?

  During 2019 I expect a recession and eventually a reversal of the Fed’s tightening. However, the very overpriced stock market will continue to go down until it reaches fair value of roughly half of its peak. Once momentum has been broken and confidence has been lost then today’s investors motivated by technical trading tools, will exit stocks until chart formations and a huge increase in liquidity inspire them to start a new upward cycle after the recession has bottomed. Today is like the beginning of the tech stock crash of April, 2001, where it had topped out Sept., 2000 and ultimately bottomed with a 78% decline for Nasdaq in Oct., 2002. Thus, by analogy we have another 18 months of relentless declines before stocks bottom. And when they bottom out stocks may merely move up modestly since PE10 indicates fair value is at half of today’s prices.

   The big mystery is how will the over-indebted EU, with its structurally unsound supra-national government, and Japan get out of their problems and return to a normal economy with normal interest rates, low debts, and plenty of demand? How will China get out of the mess of excessive real estate bubbles, empty unrented homes, an overpriced currency, and too much debt? These problems are so huge they hint at a future of a global depression instead of a routine recession. The idea of being threatening by rising interest rates or rising inflation seems ludicrous. There is significant risk that rising unemployment outside of the US (caused by the next global recession, next year) will result in more American jobs being exported to low wage countries, leading to rising unemployment here.
Investing legend Stan Druckenmiller said yesterday the best economist is the collective judgement of the markets, implying that if stocks crash and bond yields go down when the Fed raises rates, then the Fed has made a mistake. He said he made most of his money by profiting from the Fed’s mistakes, implying that owning long term Treasuries was a way to profit from Fed mistakes.
Investors need independent financial advice about the risks of a deep systemic stock crash.


2018-12-19T14:21:37+00:00December 19th, 2018|mayflowercapital blog|Comments Off on Fed Raises Rates, Market Cuts Them

About the Author:

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.