MORE ZIRP PLEASE – EXCUSE ME? 

Much ink has been spilled for much too long by everyone trying to anticipate the timing and magnitude of the Feds move on interest rates.  Specifically, when exactly the Fed might feel comfortable enough with the business environment and compelled to begin the interest rate normalization process and raise their target for the fed funds rate.  I too have spent an inordinate amount of time listening to conference calls, reading transcripts, and examining the various econometric models to try to gain some insight into this enigmatic issue.  I say “enigmatic” because this whole matter has become very complicated in recent years as we continue to work through all of the imbalances that were created with 2008-2009 credit crisis and the bubbles that led up to that event. 

 

The Fed’s move a few weeks ago to the surprise of many to hold the fed funds target at or near zero added further complexity and head-scratching.  With that move, we may be witnessing a Fed willing to accept an additional, albeit unspoken, mandate.  As you may already know, the Federal Reserve is independent, but also serves at the direction of the US Congress with two formal mandates: 1) pursue full employment, and 2) defend the US currency (that is, fight inflation).  However, at its most recent meeting, the Fed seems to have bowed to pressure from the ECB (European Central Bank) and various developing countries to refrain from raising the fed funds target for fear of further strengthening the dollar.  Had the Fed raised interest rates at their last meeting, undoubtedly further havoc in commodities markets would have ensued, along with further depletion of ECB and Chinese foreign currency reserves.  Most assuredly, every dollar-denominated commodity would have sold off even further, including crude oil, iron ore, coal, natural gas, copper, and gold. 

 

Some cooperation by the Fed with other central banks really is nothing new.  For several years now, all central banks have been working together to a degree to stem the tide of massively excessive global supplies of just about everything, including commodities, labor, and especially money reserves.  However, if the Fed were following exclusively its congressional dual mandate, it would have certainly began the interest rate normalization process at its October meeting.  At that time, it really had the best opportunity it’s going to see to begin this process as the financial markets were primed for such a course. The fact that the Fed stayed pat on interest rates really does suggest that, to the extent inflation is dead and unemployment is improving, a higher degree of interest rate coordination with our trading partners may be tolerable.

 

This does make sense in consideration of the fact that most all developed countries and many developing countries are coordinating most every other aspect of international trade, also known as “globalization.”  However, this apparent monetary coordination does raise more intermediate concerns about what imbalances may be building from such a coordinated low interest rate for so long.  I do worry about the worldwide impact to unemployment once global interest rates do begin to normalize and all of the industries that have been built around zero interest rates suddenly find their already thin margins simply evaporating from higher interest rates. 

 

I also worry somewhat about how this newfound unspoken mandate of the Fed might be perceived by Congress.  I’m sure chairwoman Yellen will face a grilling at her next Humphrey-Hawkins testimony over this potential over-reach.   

 

The point of all this so far as the management of your investment accounts is concerned is that if the Fed has indeed adopted a more global view of monetary policy, then to the extent that Europe is in a deflationary spiral and China is slowing down, interest rates may very well stay at or near zero for years to come.  In fact, there is some speculation that interest rates may actually have to go negative in the event US growth begins to recede.

 

The obvious ramification of such a scenario would be that we would want to extend the maturity of any bonds in your account.  We have been pretty conservative for a while with bond holdings opting for shorter maturities in order to protect against the potential of rising interest rates.  If we are correct in our assessment of interest rates, we may be able to actually boost the yield on bond holdings in the coming months. 

 

In addition, companies that would benefit from a modestly weaker dollar would be good additions to the equity side of your account.  To that end, we are reevaluating most of the industrials (Boeing, Towers Watson, and the Railroads) and technology companies (Alphabet, Apple, Salesforce.com, Facebook, PayPal, Hewlett-Packard, Microsoft, and Accenture) as these firms tend to export rather heavily.  A weaker dollar will make their products and services cheaper in the markets they are exporting into.  

 

One final idea that we are still trying to get our heads around is the prospect of negative interest rates should the US economy slow into a recession and were the Fed to implement such an unusual policy.  We are giving a good deal of consideration to the possible ramifications to the economy, consumer and investor behavior, and ultimately your investment account under such a policy.  My hope is that the global economy begins to recover before such a twisted view of monetary policy comes to any serious consideration by the Fed.  But, “hope” has never been a particularly good investment strategy, so we have to consider the absurd sometimes.

 

Sincerely,

 

Mark P. Culver

Managing Partner

 

 

 

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