There is no free lunch - higher rates equal higher risk

Tuesday, May 03, 2005

Expectations that the Federal Open Market Committee (FOMC) will hike the Fed Funds rate to a level of 3 percent from the current 2.75 percent have helped to stabilize the US dollar against the Euro and the Yen since the latest FOMC meeting on March 22. Higher interest rates would make the ailing greenback more attractive is a thesis that cannot only be found on the website of the Chicago Fed, but has become a popular explanation popping up in countless investment advice publications from banks and the mainstream media. Economic theory and history suggest otherwise. Unbelievers of this proven fact can only resort to the dreaded "this time it's different" superstition to support a different assumption for the future. But be warned: It's never been working.
Every trader knows the first rule of thumb in investment that goes as follows: Higher chances of return are equalled by a higher risk. If you go for a return of say 3 percent your positive expectations will be matched by an equal risk that your investment might result in a 3 percent loss. If you look for 10 percent gain you have to be prepared not to shed tears for an equal loss. And if you fancy returns of 100 percent, for example by speculating in the options market, you have to be prepared for a loss of the same size. There is no exception to this rule, history shows. And don't forget about the second rule in investing: As long as there has been fiat money the markets have worked in cycles from top to bottom and back. It was never different.
The thesis that the dollar will stop its slide against the other major currencies because of higher rates does not find an example in history since exchanges rates started to float in 1971 after the abandonment of the Bretton Woods agreement that had pegged currencies to the dollar and the dollar to gold at a price of 35 greenbacks per ounce.
Looking back at the recession in the 1970's that came along with higher interest rates that topped out at a level of 19.1 percent in January 1981 for Fed funds, the dollar had tanked by then anyway, losing about half its value against the Deutschmark and the Yen in the preceding 10 years. This was also the period of the highest rate of inflation encountered since 1948. Annual inflation had reached a maximum rate of 16.8 percent in January 1980, coming on the wings of the all-time top in oil prices at 85 dollars in current inflation-adjusted dollars.
History also shows that there has never been a period of rising interest rates that was not accompanied by a declining share market, shortterm aberrations excluded. Wall Street only resumed its upward path once the Fed loosened its tight fist and let money supply grow again. There is a lot of academic discussion whether the depression in the 1930's could have been avoided, had the Fed lowered interest rates. Today's economists like to connect the sideward path of interest rates with the crash of '29 and the following depression as a result of it.
Short excourse from the original topic: In my opinion every recession is the normal result of the basic problem in capitalism which is over-investment in new industrial sectors. Want some examples: GM had a good time until the end of the millennium, but had you invested in some other of the 3,000 carmakers that put their vehicles on America's roads in the past century you are most likely to have lost your entire investment long ago. If you still disagree about the problem of over-investment, think of the internet bubble. You did fine with Netscape or Yahoo, but what became of and thousand other internet IPOs!? End of excourse.
The markets advance in the 1960's came on the back of low interest rates. The decline in the 1970's was accompanied by rising interest rates. The longest bull market in history lasted from 1982 to 2000. It started on the wings of declining interest rates and ended with the tightening of Greenspan's Fed. The current lacklustre performance of Wall Street is again accompanied by rising rates. History and cycles will always repeat themselves.
The same applies to currencies. The currency that becomes stronger by rising the risk premium (euphemistically called interest) has yet to be invented. The stronger a currency is perceived by investors the lower will it's real interest rate be. The dollar still has to catch up a lot only to return to a positive real interest rate, that is interest after deducting inflation.
The Fed's walk on the tightrope is all the more difficult as higher interest threaten not only to curb the fragile growth but will widen the budget deficit more since newly issued Treasury debt papers will carry a higher coupon. On the other side the Fed has to fight the latest indications for an uptrend in inflation that threatens to undermine the greenback evermore.
Three possible market reactions
Today's FOMC meeting can result in three outcomes for the markets. Market talk circles around the wording of the interest rate decision.
1) If the Fed indicates that it will stay with its recent policy of "measured", i.e. 25 basis points, rate hikes, markets should stay calm and prolong the current seesaw pattern.
2) If the Fed decides to indicate a break in the current cycle of rising interest rates this should give stock and bond markets a shortterm boost before traders will be overcome by concers about slowing economic growth. This should also lead to a weakening if the dollar.
3) If the Fed surprises the vast majority of market participants with a rate hike of 50 basis points on the basis of stronger concerns about the inflation outlook, equity and bond markets will probably react with a nosedive whereas the dollar could see a shortterm rally that will be explained with the fundamentally wrong argument that the currency begins to look more attractive. In part this might be absurdly correct though as the Euro and the Yen are certainly burdened with similar bad economic outlooks as is the dollar which lessens their appeal as well. The Euro area is still to be favored a little more over the dollar as inflation remained stable at 2.1 percent in April, Eurostat reported last week. On the other hand did European manufacturing decline for the first time in a while, indicating still lower growth than the latest projection of 1.0 percent. The Yen is no investment alternative either. The Japanese ministry of finance expects stagflationary conditions to remain for at least another two years.
Buying Swiss Francs in this case and leaning back to watch the race of the three ugly ducklings might not be the worst investment decision in this case. The Swiss Franc has often proven to be the ideal reserve currency in times of global economic uncertainty as its limited supply and the relatively highest gold reserves of all nations easily result in a rally when demand pushes it up. Don't expect a high risk premium, i.e. high interest rates though. As explained before a strong currency does not need to be held up that way.


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