3 Reasons a U.S. Interest Rate Rise Would Be Purely Symbolic

Why should Aussies care anything about U.S. interest rates? I’ll share more on that later. First, here’s a brief overview of the economic predicament that American regulators currently find themselves in.

In the wake of the global financial crisis, the Federal Reserve (Fed) went on a tear, slashing the target funds rate from 5.25 percent in September 2007 to nearly zero percent by December 2008. That amounted to a drop of over five percentage points in only 15 short months.

As you may remember, those were desperate times. The U.S. housing market was imploding, highly leveraged banks, insurance companies and government-sponsored agencies were collapsing, and the U.S. stock market began a steep decline. By reducing the cost of borrowing, the Fed’s hope was to encourage households and businesses to finance new spending to help support the price of assets, namely shares and real estate.

Photo by AgnosticPreachersKid / CC BY-SA

The concept of lending money for free is a new one. Until the past decade, no major central bank has ever, in the history of the world, set short-term interest rates at zero, even during periods of deflation.

We’re now almost seven years into the Fed’s monetary experiment, and as you would expect, they are now under pressure to begin lifting rates. Most people understand that artificially low interest rates suck long-term.

Last week, the Fed Vice Chairman, Stanley Fischer, said the United States central bank is planning to follow a “gradual and relatively slow” trajectory of interest rate increases. Their goal is to bring the funds rate back to a “normal” range of 3.25 to 4 percent over the next three to four years.

In other words, he anticipates a quarter of a percent increase about every three months. And it’s anyone’s guess when this might begin.

A few days before Fischer’s comments Fed Chairwoman, Janet Yellen, claimed the central bank is on track to begin raising interest rates sometime this year. However, she said they would proceed cautiously, because the job market hasn’t fully recovered, inflation is too low and growth remains meager at best. Economists have already pushed back expectations of a hike from June to September, and now to December or later.

So, what do you reckon? Do you think the Fed can pull off a rate increase anytime soon? It would help to know if they’ve been able to do it before.

Fischer’s proposal is a noticeable contrast to the last series of rate increases that took place from 2004 to 2006. During that stretch, the Fed raised the benchmark rate from one percent to 5.25 percent. In other words, it increased in increments of .25 percent at each of 17 consecutive monetary policy meetings.

Since the board meets about every six weeks, this means that Fischer’s “gradual and relatively slow” plan is to take about twice as long to travel the same distance as they did in the last series of increases.

But those were different times. Seven years of near zero interest rates has changed the economic landscape. Just like an addict who gets hooked on drugs, the financial markets seem to have become dependent on free money.

While the Fed’s plan for future rate increases sounds measured and reasonable, the economy’s new addiction has handcuffed the regulators. This is why any interest rate rise in 2015 will be purely symbolic – to give the impression that the Fed is still in control.

Former Fed Chairman Ben Bernanke agrees. According to guests at a private dinner meeting held for wealthy hedge fund investors, Bernanke said a year ago behind closed doors that he doesn’t expect to see the federal funds rate at its long-term average of four percent at any point during his lifetime. Ben is now 61, and surely he plans to live for another 20 years, at least.

Here are three reasons we shouldn’t expect a significant U.S. interest rate rise anytime soon:

1. It Would Bankrupt The U.S. Government

The U.S. national debt is already over $18 trillion and growing. As you would expect, the U.S. government pays interest on this debt. For fiscal year 2014, their total interest expense was over $430 billion.

In the same year, the U.S Government took in about $3 trillion in tax receipts. Government spending for 2014 totaled $3.5 trillion. In order to meet obligations, they borrowed about $500 billion to cover the budget shortfall, which was just enough to pay the interest payments.

In case you missed that, the government now borrows money just to pay interest on its debt. It’s no wonder that some are saying that Uncle Sam is already bankrupt. If you were borrowing money just to make your interest payments, how long do you think you would survive?

Not only is that unsustainable, it also reveals just how far on the knife’s edge America really is. If they have to borrow just to make interest payments on debt that’s increasing daily now while interest rates are minimal, what will happen if interest rates increase?

For the U.S. government, a minimal one percent increase in interest rates would equate to over $100 billion more in interest payments. If interest rates were to normalise to around four percent, their interest expense alone would double to nearly $1 trillion per year.

Based on this reality, Stanley Fischer likely knows that four percent in four years is unachievable. The Fed clearly does not want the U.S. to be the next Greece.

2. It Would Implode The Bond Market

On the question of whether the Fed will raise interest rates, most people look to the economy for signs of strength or weakness, but what people really should focus their attention on is the current bond bubble.

Bonds represent debt. Because interest rates have been at historically low levels for the past seven years, nations and companies have been borrowing more and more by issuing debt in the form of bonds. The yield paid to investors of those bonds is a reflection of the prevailing interest rate.

Bond values have an inverse relationship to yields, or interest rates. As interest rates increase, bond values decline. If bond values decline, the investors who own the bonds begin losing their principal.

Since we’re property investors, let me explain the same concept using real estate. Let’s say you invest $1,000,000 in a commercial property that will pay you $60,000 per year in rent. That’s a six percent yield.

After you buy the asset, interest rates begin to go up. Within a few years, investors no longer need to take on the risk of owning a commercial property to get a six percent return. Now investors demand an eight percent yield in the same area to compensate them for the greater risk.

Your property still brings in only $60,000, but based on an eight percent yield, your property is now worth only $750,000. In this case, a two percent change in interest rates has resulted in a 25 percent loss in the value of your asset.

Higher interest rates would have the same effect on the bond market. An investor who purchases bonds based on a one percent yield would lose half of their investment if interest rates doubled to two percent. Think back to how much wealth has evaporated when real estate or share market bubbles have burst. Due to the amount of worldwide wealth currently held in bonds, any dramatic movement north in interest rates would have epic ramifications on the world economy.

Warren Buffet recently said that he believes the bond market is grossly overvalued. Bond expert Bill Gross recently made similar comments. For similar reasons, these Aussie bond investors are also expecting global interest rates to remain lower for longer.

The impact of higher interest rates on the bond market will be weighing heavily on the minds of the Fed board members in the coming months.

3. It Would Crash The U.S. Equities Market

Fed Chairwoman Janet Yellen commented earlier this month that U.S. share market valuations are “generally quite high.” Shares have been on an upward trajectory since 2009, about the time the Fed fund rate bottomed out.

Low interest rates mean that investors don’t make money when they park cash in the bank. In search of higher returns, investors look to riskier assets, like real estate and the share market. This investor speculation in part explains why stocks in the U.S. have been on the rise, but that’s not the whole story.

For at least the last three years, the primary driver of equity values has been corporate buybacks. Just like individual investors, corporations need something to do with their cash. With the economy still uncertain, rather than spend that money on internal investments that might not pan out, instead, companies have been returning that cash to shareholders by buying their own stock.

When companies buy back their shares, the prices of those shares go up. This explains why corporate executives sitting on stock options are big winners of this strategy. In fact, ever since these corporate buybacks began, insider sales have reached record highs.

In the previous months, we’ve already seen sell offs in the share market as investors grow increasingly anxious over a possible Fed rate rise. A lot of American’s wealth is tied up in shares at the moment, and while Yellen has already commented that the market is overvalued, she would prefer a measured decline, rather than a dramatic collapse.

Why Should Aussies Care About U.S. Interest Rates?

Anything more than a symbolic rise (perhaps .25 percent) in interest rates could have dramatic unintended affects. Don’t be surprised if we see the Fed kick the can farther down the road with plenty of rhetoric, but little action.

Unless you’re investing directly in the U.S., you probably have little concern for the Fed’s actions. After all, what direct impact could they have on Australia?

The Federal Reserve’s actions actually do have a significant impact on the Australian economy. The RBA is watching the Fed closely to see what their next move will be. Our central bank’s stated aim is to devalue the Australian dollar in the near term. Glenn Stevens would like to see our currency trading under US$.75.

Remember, we measure the value of the Aussie dollar in terms of its relationship to the U.S. dollar. If the Fed raises interest rates, this will put upward pressure on the U.S. dollar. If the U.S. dollar strengthens, the Australian dollar will get weaker, all else being equal.

This is a win for the RBA. If the Fed raises rates, the RBA gets what they want without having to lower interest rates any further. This would be a massive relief for our central bankers, since they already need help from APRA.

However, if the Fed doesn’t raise rates, and the Aussie dollar doesn’t get weaker, the RBA may need to lower interest rates again. And we all know how the Aussie real estate market has been responding to the RBA’s recent moves.

If we take this a step further, any prolonged weakness in the U.S. dollar puts more pressure on the RBA to keep lowering rates. If we see future Aussie rate reductions, this could continue to produce unintended consequences in the real estate market. Once APRA has run out of tricks in its bag, then it’s over to Joe Hockey to work his magic on the tax code.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.