Why the Fed Raised Rates Last Year And Will Do So Again This Year

The Fed raised rates in 2015 to protect the dollar and demand for Treasury Bonds.

They will do it again in 2016.

Fed credibility supports the dollar, lack of Fed credibility weakens it.

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The Fed and U.S. Treasury Bonds

Protecting the dollar and demand for U.S. Treasury Bonds is more important than the Fed’s dual mandate of full employment and price stability. It’s also more important than funnelling favors to its too big to fail bank shareholders. Without demand for the dollar and Treasuries, the proper functioning the U.S. economy and its deficit fueled government become tenuous.

The launch of quantitative easing in 2009 by the Federal Reserve caused alarm among foreign holders of U.S. Treasuries. If the United States could just print money to buy bonds, and lower rates to zero, thus devaluing Treasury Bond holdings, what would stop them from doing it ad infinitum?

Foreign central banks hold trillions of dollars in U.S. Treasury Bonds as reserves because they are considered safe, liquid and needed to buy oil and to conduct international trade. If however, those bonds are subject to reckless whims by the Federal Reserve, holding U.S. Treasuries becomes a less compelling proposition.

There has been some indication that demand for Treasury bonds by central banks is waning for a variety of geo-politcal and economic reasons. Countries like Russia and China have diversified their reserves by adding gold and selling U.S Treasuries. An interest rate hike reasserts the value proposition for Treasury Bonds as they pay a positive yield unlike most sovereign bonds and the Fed is seen to be increasing rates in a world where most central banks are lowering them and their bonds have negative yields.

The Never Rate Hike Crowd

Last summer, when many commentators were saying the Fed wouldn’t/couldn’t raise rates or indeed could NEVER raise rates, we asserted they would in The Fed Will Raise Interest Rates. The rational then and now is that the Fed has to protect the dollar and demand for Treasury Bonds.

Smaulgld Podcast From May 2015

When the Fed finally raised rates in December 2015 as we predicted, we wrote in Why The Fed Raised Interest Rates the following that still holds true today

What’s next for the Fed?

We believe the Fed will continue to push the concept that they are on a rate hike path (data dependent, of course) because the economy is improving and that “job gains” will eventually boost consumer spending and inflation. Having gained credibiity for raising rates, Ms. Yellen and Fed officials will talk about another rate hike for months sending conflicting signals that they might raise rates, might not raise rates or might lower rates.

The Fed won’t throw the towel in and reverse course until either the data clearly indicates a recession or another financial crisis occurs brought on by the bursting of the shale oil or sub prime auto bubbles.

Negative Interest Rates and QE4

Either a recession and/or another financial crisis are inevitable. This will lead the Fed to reverse course and, as we originally predicted when Janet Yellen was appointed to the Fed Chair position, to institute negative interest rates and eventually embark on QE 4.

The Fed is very clever. If the Fed had said at the beginning of the first QE program launched in 2009 that they would print over $4 trillion over the next seven years to buy U.S. Treasury bonds and worthless mortgage backed securities and that they would keep interest rates at zero, the dollar would have collapsed. That is exactly, however, what they did but the dollar did not collapse and indeed is higher today than it was before they started QE in 2009!

The Fed achieved this feat by talking about someday NOT doing what they did and the markets believed them.

Will they listen next time?

Update May 2016: What’s next for the Fed?

The Never Rate Hike Crowd Again

Many of the same commentators who rejected the possibility of a Fed rate hike in 2015, said after the Fed raised rates that they would not do it again and some said the next Fed move would be to cut rates. While we ultimately believe the Fed will cut rates and launch QE 4, we believe the next Fed move this year is another rate hike.

The Fed is determined not to let the demand for Treasuries or the dollar slip.

It appears markets still hang on every word coming out of the FOMC minutes and the mouths of Fed Presidents and Fed Chair Janet Yellen. For this reason, four non voting Fed members (Williams, Lockhart, Lacker and Kaplan) have been talking up a storm re raising rates this year more than once. The Fed knows that raising rates can harm the economy and hence the dollar, but it also knows that by not raising rates the dollar weakens.

The Dollar Needs to Stay Range Bound

The Fed does not want too strong a dollar or one that is too weak. They would prefer not to raise rates multiple times in 2016, so they have non voting members express their support for multiple rate hikes, knowing they won’t have egg on their faces if the Fed doesnt raise rates or raises them only only once, because Messrs. Williams, Lockart, Lacker and Kaplan can always say they WOULD have voted for a rate hike(s) but couldn’t. The Fed knows they are in an untenable situation that either raising rates or not raising rates has significant downsides.

The Fed’s credibility, the dollar and demand for U.S. Treasury Bonds is on the line. Just talking about a rate hike won’t cut it. They’ll do another quarter point hike then start the yacking about doing another one.

We don’t buy the argument that the Fed can’t raise rates because it would increase the debt service to levels that the U.S. couldn’t afford. The U.S. already can’t afford its annual deficit, accumulated debt and unfunded liabiities. The only way they get paid is by issuing more debt. If raising rates attracts more demand for government issued debt, they will do it. How will the additional interest be paid? From the principal of the newly issued bonds.

The same people making the argument that the Fed can’t raise rates due to the higher debt service payments are the same ones who call the U.S. debt scheme a “Ponzi Scheme”. Ponzi 101 says you constantly have to raise more capital, however possible. If raising rates attracts more capital, the operator of a Ponzi scheme is compelled to do it.

A rate hike won’t mean the economy is doing better, just the Fed trying to maintain its credibility and supporting the dollar and demand for Treasury Bonds.

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