Will The Fed Normalize Rates? Three Reasons Why It Won’t (Can’t)!

By | September 10, 2015

Will the Fed announce that it is raising rates a quarter point at the FOMC meeting that ends on September 17th, or will it stand pat?

Inquiring minds want to know, particularly in some of the interest rate and economically sensitive sectors such as investments, banking, real estate and mortgages.

But, as I conjectured in an article last week (U.S. Business In The Hands Of Federal Reserve Academicians!), the Fed has already effectively placed itself ‘between a rock and a hard place having kept interest rates at 0% during what has been labeled an economic expansion, a time that interest rates would typically be raised (or at least be off of a 0% base).

The problem has been that since the financial crisis reportedly ended, 0% interest rates have not increased inflation (deflation actually might be more of a concern) and despite a 5.1% unemployment rate, the masses on Main Street are still suffering economically.

So assuming that my above thesis is correct, a thesis that doesn’t take into account the weakness that many economies around the world find themselves in, can the Fed raise even 1/4% and risk recession here in the United States?

My personal opinion is that they have no intention to do so but, are there even more reasons why this may be the fact beyond simply the recession argument?

The answer is yes according to an article at the financial blog Zero Hedge. They in fact cite three glaring reasons why if we assume that at some point the Fed does actually raise rates, it won’t go beyond symbolic moves to a level of .35% to .5%.

And, for you history buffs out there, the norm has been in the 4% range.

Three Reasons the Fed Cannot Let Rates Normalize

‘1)   The $9 trillion US Dollar carry trade

2)   The $156 trillion in interest-rate based derivatives sitting on the big banks’ balance sheets.

3)   The weak US economy cannot handle rate normalization

Regarding #1, there are over $9 trillion in borrowed US Dollars floating around the financial system invested in various assets. When you borrow in US Dollars you are effectively shorting US Dollars. So if the US Dollar strengthens, you very quickly blow up (carry trades only work when the currency you are borrowing in remains weak or stable).

Regarding #2, bonds are the senior most collateral backstopping the derivatives markets. Over 77% of derivatives are based on interest rates. This comes to roughly $156 trillion in interest rate-based derivatives… sitting on the big banks’ balance sheets.

If even 0.1% of this money is “at risk” it would wipe out 10% of the big banks equity. If 1% were “at risk” it would wipe out ALL of the big banks’ equity.

Suffice to say, the Fed cannot afford a spike in interest rates without imploding the big banks: the very banks it has spent trillions of Dollars propping up.

Finally (#3), the US economy cannot handle a normalization interest rates.

This is not the usual “the Fed cannot raise rates ever” nonsense. It is more a structural argument. A sharp drop in business investment is what causes recessions. When businesses stop investing, job growth slows and the layoffs start soon after. This is how a recession begins.

With corporate profits already falling, US corporations already have less cash available to pay off the gargantuan debt loads they’ve accrued in the last six years (courtesy of the Fed keeping rates at zero). A spike in rates would only accelerate the pace at which corporations cut back on investment, as they have to spend more money on debt payments. This in turn would trigger a recession.

So will the Fed raise rates or won’t they? T-7 days to find out!

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Article by Michael Haltman, President of Hallmark Abstract Service in New York.

HAS is a provider of title insurance in New York State for residential and commercial real estate transactions.

Learn more about Hallmark Abstract by watching our whiteboard animation here.

One thought on “Will The Fed Normalize Rates? Three Reasons Why It Won’t (Can’t)!

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