The Fed’s Real Debt Conundrum

In June, the US Federal Reserve raised the cash rate for the seventh time since 2015. No sooner had it announced the news, than the market immediately factored in another two rate rises before Christmas.

Usually, a series of rate increases like this happens as an economy is growing apace. That is, when the economy is growing at full stream.

The idea being that a higher cost of money reduces demand. Not only with increased borrowing costs for businesses, but consumers spending less as they have less money in their pockets.

Getting the timing right is no easy feat

As we know, though, getting the timing right is no easy feat. Raise rates too early, and you kill the economy just as it’s getting on its feet.

Raise rates too late, though, and a bubble could already be forming. By then, asset prices may have run so far that only a correction will bring them back to par.

However, it’s not just a bubble in asset prices that are the concern. It’s also the size of overall debt.

Increasing rates rapidly towards the end of the cycle raises several risks. First, that interest rates increase just as the economy slows down.

Those that have leveraged themselves too high run the risk of imploding. A slowing economy can mean slower sales, just as interest costs increase.

It can also mean that the ratios banks use to assess loans might no longer stack up. As asset prices fall, and debt remains the same, companies could breach loan covenants even if their repayments are up to date.

The other risk is to do with data. As most economic data is historical, the rate increase could come well after the economy slows down.

For a central bank, it’s an almost impossible task to get right.

If you want to protect your family wealth, you need to know why this financial expert is predicting economic collapse. Find out more.

With unemployment in the US at historic lows, and its economy booming, the Fed is now in a game of catch up. It wants to raise rates to ‘normalised’ levels, so that it has some firepower when the cycle next turns down.

The problem is that the Fed is raising rates as emerging markets around the world are tanking. In August, the MSCI Emerging Markets Index marked a 20% fall this year.

However, the stock market is just one piece in the puzzle.

If not more important, is the level of government (and corporate) debt. The Fed wasn’t the only central bank to pump money into their economies post-GFC.

Europe, Australia and just about every developed (or developing) market borrowed money to keep their economies afloat.

The difference between the US and all these other emerging markets is that it printed its own currency to fund much of its debt.

For all the other emerging markets, they had to borrow — often in US dollars. And it is with these US dollars they need to repay this debt. Unlike the US, they don’t have the luxury of printing US dollars.

The more they print their own currency, the less its value holds. Because of that, their economies fall into a hopeless spiral as they attempt to repay debt with an ever-falling currency. And to make things even tougher, often when its economy is starting to splutter.

As the US raises rates, and others don’t, it not only increases the value of the US dollar. It also causes money to flow where it can generate the best return.

With higher rates on offer in the US, some of that money inevitably comes back home.

It’s not just an issue of money flow. It also has to do with financing. Developed markets, or those with excess capital, lend to emerging economies thereby helping to fund their economies.

Even a developed economy like Australia is reliant on foreign debt. And it’s not just the government. Our banks rely on foreign debt to help fund their loan books.

If this funding dries up, or the cost of borrowing becomes too high, it inevitably curbs the level banks will lend. And this is what starts to put a handbrake on the economy.

The US Fed faces a conundrum

That’s why the US Fed faces a conundrum. If they raise rates too high and/or quickly, it could sink emerging markets even further. And that means a likely increase in loan defaults to US based institutions.

What’s more, it could even sink its own economy, as its citizens struggle to repay their ballooning debt. That could happen just as jobs growth, and employment, may have peaked.

The other thing the Fed has to consider is exports. If the dollar rallies too high, it could really harm those businesses that sell their goods and services offshore. Put simply, US exports could become too expensive.

There’s no doubt the Fed needs to walk a fine line. If it raises rates too far and quickly, it could pull the rug on all those emerging countries…even its own economy, and pull the global economy down.

Yet if it keeps rates too low, the asset bubble could grow further, leading to an even bigger correction when the economic cycle eventually turns down.

All the best,

Matt Hibbard
Editor, Options Trader

PS: Financial expert Vern Gowdie explores why a credit collapse could occur in 2018, and how you can protect your assets. Click here for free action plan.

While many investors chase quick fire gains, Matt takes a different view. He is focused on two very clear goals. First: How to generate reliable and consistent income in a low-interest rate world. And second, how you can invest today to build wealth over the next 10–15 years. Matt researches income investments. You can find more of Matt’s work over at Total Income, where he is hunting down the next generation of dividend-paying companies for the future. He is also the editor of Options Trader, where he uses basic options strategies to generate additional streams of income beyond the regular dividend payments. Having worked for himself and with global firms for almost three decades, Matt has traded nearly every asset in existence. But now he is on a very different mission — to help investors generate income irrespective of what the market is doing. It’s about getting companies to pay you a steady, stable income, with minimal stress and the least risk possible. Matt doesn’t believe you have the luxury of being a bull or a bear in the market right now. You have to earn an income from it, regardless of whether stocks are going up or down. By getting the financial markets to pay you an income, you can get to focus on more important things than just money.

Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money