Is this Rate Hike Rigged?

Rodney Johnson |

It’s official.

This week, the Federal Reserve raised the key overnight Fed Funds rate by 0.25%. The move was discussed, debated, argued, and telegraphed to death. We all heard about it until we hoped anything else financial would happen so we could finally put the tired story to rest.

Now that the rate hike is on the books, though, we can start talking about outcomes: like how in the world the Fed intends to enforce the rate hike, what it means, and what comes next.

The first one is not so simple, the second is annoying, and the third is downright depressing. But we’d better start planning for this today, because it will definitely affect our investments in the months to come!

This rate hike is unlike any other. It comes on the heels of several quantitative easing programs that have dumped trillions of new dollars into the banking system.

Before the financial crisis, banks held about $60 billion of excess reserves at the Fed. These are funds above and beyond their required reserves.

Today, excess reserves total about $2.6 trillion, which represents part of the money the Fed printed and then used to buy bonds. Typically, this cash would have flowed into the economy through lending, but in 2008 the Fed started paying interest on excess reserves, which has kept the funds out of circulation.

With so much extra cash in their accounts, banks have almost no need to borrow from each other.

This creates a problem for the Fed, because adjusting the rate at which banks lend to each other, called the Fed Funds rate, is how it historically enforced its interest rate policy. Starting this week, the Fed will have to use new, largely untested tools.

Since there is almost zero demand for money between banks, the Fed is increasing the interest it pays on excess reserves from 0.25% to 0.50%.

A $10.5 Billion Gift to Banks

At the same time, the Fed intends to lend out up to $2 trillion of its own stash of bonds in the overnight repurchase market. It will lend these to banks, money market funds, and other institutions for one night, with an agreement to buy the bonds back the next day at a slightly higher price, effectively paying the counterparty 0.25% interest.

It’s more than a little backwards.

The upshot is that instead of banks paying each other the higher rate of interest after a rate hike, now it’s the Fed, which means it’s really me and you, since the Fed gets money by taking value from the rest of us. At the new, higher rate, this is about $10.5 billion per year that is nothing but a gift to banks.

And don’t expect your deposit rate to move higher anytime soon. Banks pay interest to depositors to attract and retain cash. Right now, they don’t need your money. As for what lies ahead, expect uncertainty, which is a word the markets hate.

In her press conference after the Fed meeting, Chair Yellen went to great lengths to explain that subsequent rate changes would not be mechanical, incremental hikes at regular intervals.

Instead, she described the rate of increase as gradual, with each decision depending on market factors affecting inflation and employment.

Sound Familiar?

The most powerful financial regulatory body on the planet once again told the world that while they think rates will be higher over the next couple of years, they will examine every piece of evidence as it comes along.

In doing so, they reserve the right to raise rates, keep them the same, or even lower them if necessary. All of which leaves investors hanging on every data point as we approach each Fed meeting over the next couple of years, agonizing over whether or not there is enough strength for higher rates.

We don’t think there will be.

Even though the Fed’s consensus estimate is for overnight rates to reach near 1.50% by the end of 2016, we see the US economy rolling over next year, which should make the Fed more accommodative, not less.

Whatever they choose to do, let’s hope that Janet & Company buy a really big bullhorn and use it to make their intentions known. Otherwise, we’re all going to be stuck spending a lot of time, and spilling a lot of ink, on the same old subject for the next several years.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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