Time to Rip Off The Band-Aid

Posted in: Economics, General, Stock Market, Thought of the Week

The Fed waged a war on seniors and savers during the financial crisis by lowering interest rates down to the zero level. Today, the majority of the talk on Wall Street is when they will finally end this war and enact the first rate hike since 2006. Before we discuss the implications of the Fed lowering their weapons, let’s quickly recap how we got here.

In times of weakening economic activity and particularly recessions, the Fed will lower interest rates to make credit more available and inspire consumers to take out loans to buy goods and incentivize companies to issue bonds to raise capital to expand their businesses. The financial crisis was such a deep and violent downturn that the Fed felt compelled to take rates as far down as possible, which is right around zero percent.

However, the Fed has a long history of confusing academic theories with the reality of consumer behavior, and this time is no different. Their flaw is more apparent when one considers the difference between low interest rates and zero interest rates.

Let’s walk through a not-so-hypothetical scenario that will most likely hit home for many readers. Take a conservative investor who did everything right in her life. She never took on too much debt, always lived within her means, and avoided equities due to the volatility.

Prior to the financial crisis, she had planned to retire and invest her nest egg into ultra-safe investments like bank CDs, money market funds, and government bonds, with the hopes of earning around 6% – 8% annually to pay her bills in retirement.

However, the Fed chose to stimulate the economy by creating “free money” and in the process drove the yield on these products down to anywhere between 0% and 2% since 2008. Now she can barely pay her bills using investment income and is worried about outliving her savings. All the while, she’s watched the equity market surge in value but has not participated because of her
conservative nature.

Sure, money is cheap but how can that help someone who does not borrow money? In fact, how is this environment of artificially low interest rates help her in any way at all? Her fears consume her and rather than spend any excess income on European vacations or a new automobile, she instead hoards her cash and spends even less money, all due to her inability to generate an acceptable return on her investments.

Our Investment Committee would argue that this hypothetical situation is more real than the Fed realizes, and since 70% of our economy consists of consumer spending, this low interest rate environment has actually hurt our economy in several ways.

Simply put, the Fed’s monetary policy went way too far and has had the unintended consequence of slowing down our economic recovery rather than helping it move faster. Now that the Fed is finally considering raising interest rates, conservative investors should overwhelmingly cheer the move.

The reality of our current investment environment is that we are most likely going to be facing some big pockets of volatility in U.S. financial markets as we approach the first interest rate hike since 2006.

One outcome of zero interest rate policy is that it forces equity prices to rise, as investors seek returns in stocks due to a lack of options in less volatile asset classes. A market fueled by the Fed is quite different than one fueled by the economy, and the transition from one to the other is sure to be bumpy along
the way.

The Fed has put us in a tough spot, and getting out is going to feel a lot like ripping off a Band-Aid. At first, it will sting but it’s necessary to continue the healing process. But keep in mind that the anticipation of pain is often worse than the pain itself, and we must endure this volatility in order to get back to a normal investment environment. There’s no other way around it.

As investors, we can only prepare for the pain as best as possible and be ready to act fast if we see any major selling in stocks, since my view on the long-term direction of our economy remains unchanged. We are still in the early innings of a multi-year bull market, but it’s one that will move slowly and require investors to be patient.

The bottom line is that the Fed was wrong to keep their monetary policy so loose for so long, and these artificially low interest rates have done very little good for the broader economy. Conservative investors are strongly urged to embrace a rising interest rate environment and ignore the impending volatility that it may bring.

Read this week’s Thought of the Week to learn more about rising interest rates and its impact on conservative investors.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.