Interest Rates are Going Up - Kind Of

As a reminder, the US Federal Reserve ("Fed") has what is called a "dual mandate" although in reality it has three objectives. These are:

  1. Maximum Employment
  2. Stable Prices
  3. Moderate Long Term Rates

The first two are the dual mandate and the third takes care of itself if the first two are met. As you may have heard, the Fed hasn't raised interest rates in a very long time and when they are going to raise causes a lot of angst in the financial markets. 

Yesterday, November 6, 2015, we got a very good October jobs report. It had good news on the number of jobs created, wages, etc. This means it is highly likely the Fed will move to start increasing interest rates in December. This of course led to yield related assets selling off as interest rates rose in anticipation of the increase. 

The Journal has a nice summary of our views on the subject here. Their overall conclusion is:

The rates and dollar drag aren’t enough to keep the Fed on hold in December; it would take something like a weak November jobs report or another case of the global jitters to do that. But it does reinforce the case for the Fed, after it raises rates once, to wait for a bit and gauge the economy’s response. That is a message Fed officials will likely be sending in the weeks to come.

It would take an unambiguously strong economy for the Fed to lose its caution and start stair-stepping rates higher at regular intervals. This tightening cycle will turn much differently than in the past.

We couldn't have said it better ourselves. Interest rates are going to increase but the pace and magnitude are likely to be very slow and measured. It is important to remember this is not a normal economic recovery because we are coming out of a balance sheet recession. In other words, the recovery is much slower and more fragile than normal (only 2% economic growth vs. 3%+ in other recoveries). The Fed understands this well and will be very cautious to "do no harm" to the economic recovery.

The Dual Mandate

In addition, remember the Fed has a dual mandate and the second part of it is stable prices. The Fed does not think about stable prices as "flat prices". Ben Bernanke made this explicit when the Fed came out with a 2% inflation target (prior to this the Fed never gave an explicit number). In other words, if inflation is not clipping along at around 2%, the Fed does not believe it is meeting its mandate.

Before, you tell us that everything you buy (ex-gas) sure seems to be increasing more than 2% a year, remember the government defines inflation differently in that it gives credit for things like productivity gains. This might seem kind of crazy, but if you get a better more powerful iPhone each year for the same price (or even less thanks to T-Mobile and what they have done to the wireless market), this reduces inflation. 

As the Fed moves to increase interest rates the US dollar will increase in value as the yield paid on US Treasuries increases (higher rates, more buyers). A stronger dollar means imports to the US become cheaper. Given that the US is a net -importer (we buy more from the rest of the world than we sell), to the tunes of hundreds of billions of dollars, a stronger dollar "imports deflation". 

This sounds great for us as consumers but that does not necessarily make the Fed very happy. This, along with the "do no harm" theory, should cause the Fed to be very cautious on the timing and magnitude of interest rate hikes. 

Taking Advantage of Volatility

Yesterday and likely in the months to come, yield assets are going to fluctuate significantly in value. People will freak out and sell anything yield related. This is simply how the stock market goes too far one way and too far another way. We have invested in a few companies with yields from 7%-10% that are very well covered by cash flows even in a tighter interest rate environment. We expect that in a year when the dust has settled and we have had only a small increase in rates by the Fed, those companies will  trade at prices much less than 7%-10% yields.