Fallout From The Fed’s Rate Hike Cycle

“I’ve never been more optimistic about a year ahead than I am right now. And in 2016, I’m going to leave it all out on the field.” ~President Barack Obama

I’ve tried coming up with a snarky sarcastic comment but I’ll let the quote speak for itself…

Just remember, this is a president who has never seen a rate hike let alone an actual interest rate. This is a president whose legacy has been built on the back of free money, and now that the Fed is hiking interest rates (for the first time in ten years), he’s never been more optimistic… Yeah… Um… Yeaaaah.

The most obvious consequence of a fed rate hike is a stronger dollar. As conditions tighten here in the US and dollars become harder to come by, increasing its value. When you take into account the amount of dollar denominated debt that foreign companies OWE, you start to see the possibilities of a very strong rally in the dollar.  A lot of these foreign companies do not operate in dollars so the only way for them to get more dollars is to go into the market and sell their currency in exchange for dollars. But when the Fed hikes it is essentially telling these companies that “the dollar is going to strengthen”. Thus it is in the best interest of these companies to buy dollars now before their value increases further. The result is a lot of dollar buying and emerging market currency selling.

If emerging market currencies continue to fall, then the central banks of these nations will be forced to intervene and prop up the currency by also tightening economic conditions. According to the WSJ,

The Bank of Mexico raised interest rates for the first time since 2008, despite record-low inflation and relatively slow economic growth, as the central bank seeks to avoid further pressure on the peso after a sharp depreciation this year.

Thus we can start to see how a Fed rate hike forces the entire global economy to tighten whether it is ready or not.

EM corp debt

Source: IMF

 

And let’s face it, EM corporations are not ready for a tightening cycle because they like their US counterparts have piled on debt in record fashion, more than doubling since 2008. Thus these corporations should do quite poorly during this tightening cycle as their debt burdens become unmanageable.

With their currencies and stock markets falling in tandem, we can expect a large flow of capital out of emerging markets and into developed markets, especially into the US. This flow will benefit US safe haven assets like treasuries but more importantly, I think that the flow of capital will eventually become so severe that countries will enact capital controls.

So let’s think, what asset does well in a scenario of falling currency, rising economic uncertainty and capital controls? The first and obvious answer is gold, but I’m looking past that at a smaller more volatile asset, Bitcoin. Bitcoin is a globally traded currency that ignores capital controls, which is why it so desired during times of crisis.

The fed rate hike cycle should spark an incredibly strong rally in Bitcoin. I would go as far to say that Bitcoin could be the best investment for the next few years. And because of its relatively small market cap, a small inflow can cause a big spike in value.

And there are many events that could cause a size able inflow into Bitcoin. For example, a strengthening dollar threatens a few very important currency pegs. Much like the ECB’s QE forced the Swiss National Bank to unpeg the franc from the Euro, I suspect Fed’s rate hike cycle will force the PBoC to reconsider the Yuan peg. Any significant devaluation in the Yuan will send millions of Chinese searching for a hedge against further devaluation and I believe one of the answers to their problem will be Bitcoin. Now this is just one such scenario but I find it even more likely than I did when I first mentioned it in a previous article.

But it’s not just the global economy that isn’t ready for a rate hike. Even the US economy isn’t ready for a tightening cycle right now and yet the Fed is raising rates. In the US we’ve already had our massive build up in credit. In an “ideal” world, the central bank is supposed to prevent this credit bubble, but the Fed was too late to tighten. After all their mandate said nothing about credit. They only cared about inflation and employment. A shame they didn’t realize how important a factor credit plays in both those indicators. Since inflation never reared its head, the Fed never considered hiking interest rates. Meanwhile, useless credit continued to pile up in the economy, flooding every asset known to man on a biblical scale.

So here we are with a too much credit, rising interest rates, and tightening credit conditions. Obviously this bodes quite poorly for US growth stocks, inflation, and heavily indebted corporations. I won’t go as far as saying US real estate is in danger, because Congress just repealed a thirty year old law that essentially prevented foreign pension funds from purchasing US real estate. With yield starved pension funds around the world looking for a place to jam their money, US real estate could be a tempting choice. I will say however, that all the conditions I listed above do bode well or at least not poorly for US treasuries. I expect the yield curve to flatten, as short term interest rates rise and long term interest rates to fall or stay the same. The resulting environment would be quite bearish for US banks who will surely try and raise lending rates to make any profit. Thus we could see a spike in mortgage rates even as 30 year treasuries decline. Something similar has occurred in Europe as a result of negative interest rates. The banks need to make more money than before since their cash stored at the central bank now carries a negative yield so they carry that cost on to their customers through higher mortgages rates. That’s all for now. I think my next post will be about the current oil glut and hopefully how to profit from it.

 

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