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Is The Fed Trapped?

Posted by Thomas McDevitt, CFA, CFP, Managing Partner at PGIC on 8/2/2015 to Finance/Economics

As we pushed into the spring of 2015, everything seemed just peachy. Consensus forecasts pointed towards a rebounding economy, continued job gains, moderate inflation, and levitating stock prices. The "everything-is-awesome" and "BTFD" memes seemed like they would be with us at least for the rest of 2015. Things were looking so bright that market participants started to discount a fall interest rate increase by the Federal Reserve. 

Then the summer rolled around. Consider the following, which you may not be aware of if you do not follow financial markets too closely:

  1. Greece fell apart. Then was saved. Now it looks like their bailout is in jeopardy again. Leaked minutes of the IMF's latest board meeting, which took place this past Wednesday, showed that IMF staff members “cannot reach agreement at this stage” on whether to take part in the new bailout for Greece. The document said there were doubts over the capacity of the Athens Government to implement economic reforms, as well as the sustainability of the country's mountain of debt which is now expected to top 200% of GDP. 
  2. After the market closed on Friday, we found out that Puerto Rico will be defaulting on her debt. "Tomorrow is Aug. 1 and we don't have the money," Victor Suarez, chief of staff for Puerto Rico's governor, told journalists in San Juan, referring to a $58 million payment due on Public Finance Corporation (PFC) bonds.
  3. The price of crude oil collapsed 20% in July.
  4. Commodity prices just had their worst month (July) in four years. Commodities are now trading at levels not seen in 13 years. Yes, 13 years. Prices are even below the levels we witnessed during the 2007 - 2009 financial crisis.
  5. Resource-rich Canada just went into a recession. Their economy contracted in 6 out of the past 7 months.  
  6. For the month of July, China's Shanghai Stock Index was down 13.40% despite massive daily intervention by the PBOC. The Central Bank issued new warnings this week saying, in effect, that they will hang or shoot any and all "malicious" short sellers. China is a much bigger issue than Greece. The combined market cap of China's two major exchanges, the Shanghai and the Shenzhen, is about $10 trillion.  
  7. Since the end of April to the present, yields on junk bonds have jumped about 100 basis points to 7%, as measured by the Bank of America - Merrill Lynch US High Yield Master II Index. Stated differently, junk bond prices are starting to fall--and fall fast.  Historically, junk bonds have a very high correlation to stocks.

Classic liberals (think Smith, Locke, and Ricardo) have become very uncomfortable with the extent and duration of Federal Reserve intervention into free markets. It's time for the Fed to pursue a policy of normalization and to get interest rates to a higher "natural state" if only to have some ammunition for the next inevitable crisis. If an event were to hit the markets now, what could the Federal Reserve do?  Lower interest rates even further? We are at zero percent now. 

But with all of the turmoil that we have witnessed in just the past 90 days, is it possible for the Fed to even consider raising rates? Can an already fragile world economy absorb a rate lift off at this time?    

Is the Fed trapped? If so, how do we manage the inevitable costs of unlimited free money? 

Penn Guardian Investment Counsel, LLC is a fee-only, independent Registered Investment Advisor. To schedule an appointment to discuss your investment management or financial planning needs, please contact Thomas McDevitt, CFA, CFP, at 215-990-0781.  Visit the PGIC website.