Nine Years on, People Forget How Nasty a Rate Increase Can Be

by Jim Rickards, Daily Reckoning It’s unfortunate that we have to be spending so much time on the Federal Reserve. It’s the place to start if you want to understand a lot of what’s going on in the markets. In fact, nothing is more important — but I wish that weren’t true. I wish the central banks could go back to just being boring, opaque, marginal institutions that took care of money supply and acted as a lender of last resort instead of monstrosities that seem to manipulate and invade every corner of every market in the world. But unfortunately, that is what we have today. When the Fed manipulates the dollar and dollar interest rates, they are directly and indirectly affecting every market in the world — equities, gold, real estate, other commodities, junk bonds, corporate debt, etc. So even though I wish it wasn’t the case, understanding what the Fed will do next is the big question. Let’s take two scenarios: What if they raise rates? And what if they don’t? I’ll address both of those directly but first, I’d like to give you some background to help you understand what’s behind the debate. The Fed has certainly signaled that they intend to raise rates and it’s what the markets expect. Securities around the world are priced as if the Fed were going to raise rates. I’ve never seen anything more trumpeted and more advertised in my career. There’s good reason for that. The last time the Fed raised rates was 2006. In terms of cutting rates, they hit bottom in late 2008 when they got to zero — and they’ve been at zero ever since. It’s been six and a half years at zero. But you have to go back two years before that to find the last time they raised rates, so it’s going on nine years at this point. That’s a long time without a rate increase and people may forget how nasty they can be. I was in the markets in 1994 when the Fed raised rates, and it was a wipe out. That’s when we had the bankruptcy of Orange County, California, and other dealers went out of business. There was a bond market massacre. The same thing happened in 1987. A lot of people recall the crash of October 1987 when the stock market dropped 22% in a single day. In today’s market, that would be the equivalent of over 3,000 Dow points. Imagine the market dropping not 300 points, which would get everyone’s attention, but 3,000 points. That’s what happened in October 1987. But before that, in March of 1987, there was a bond market crash. The bond market crash preceded the stock market crash by about six months. These things can get nasty and I could say it’s been a long time since the last one. That’s why the Fed is talking so much about it. You have to go all the way back to May 2013 when the Fed was still printing money and buying bonds (long-term asset purchases as they call it) when Ben Bernanke first started talking about maybe beginning the taper. They didn’t do anything. They didn’t cut purchases and they didn’t raise rates — they just talked about it — and still the market threw a taper tantrum fit. We had the actual taper through the course of 2014. Now the taper is over, QE3 is officially over, so this thing has been really advertised for two years. The reason rates were at zero in the first place is because the Fed was trying to pump up assets. They wanted banks and other borrowers to go out, borrow cheap money, buy houses and stocks, bid up the price of assets, and create the wealth effect. Hopefully, that would make people feel richer, they would spend more money, and the economy would get on a self-sustaining path. Continue Reading>>>

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