With the world’s largest economy, the United States is closely watched by traders and investors alike.
When the U.S. economy is booming, the rest of the world grows along with it. And when it contracts, so too does the rest of the world.
Thus, as a retail trader and investor, I find it useful to review the big picture of the U.S. economy a few times each year, and to consider the implications of the trends I see.
In recent months, the Federal Reserve has indicated the possibility of an interest rate hike, while the S&P500 continues to make record highs. It sure seems like the U.S. economy is booming again…
… Or is it?
Let’s review a few facts.
Interest Rates & GDP Growth
Mainstream economic theory says that when interest rates are low, consumption and production goes up, which stimulates the economy. The lower interest rates are, the faster the economy grows.
This is the basic premise of the monetary policies carried out by the Federal Reserve.
Now if we look at the chart below, note that since the recession in the early 80’s, the U.S. has seen a gradual lowering of interest rates (Federal funds rate) until they hit a floor in 2009, and have since stayed at record low levels.
(shaded regions indicate recession periods)
Despite these low interest rates however, GDP growth rates have not only refused to go up, but have continued to trend lower:
For the past 30 years, even though interest rates have generally gone down, growth in the U.S. economy is not picking up.
So… what gives?
Because these facts suggests that either
- Mainstream economic theory is wrong; or
- There’s something wrong with the U.S. economy; or
Either way, this is not good news.
The U.S. Stock Market
So… if low interest rates did not stimulate economic growth, what did it do then?
Well, the general sentiment in the United States right now is one of celebration. Stock markets continue to make record highs even as people saw an economic contraction in the first quarter of this year.
(Interestingly, when the economy grows, they call it “growth”. But when the economy contracts, they don’t call it “contraction”. They call it “negative growth”. It’s the same with inflation. When it goes below zero, they don’t call it “deflation”, but “negative inflation”. So the next time I lose on a trade I’m going to say that I made a “negative profit” instead. Lol.)
Anyway, back to the point.
Compare these two charts, especially from 2009 (when interest rates were kept at near-zero) to the present day:
Looking at the data, it wouldn’t be a stretch to say that the near-zero interest rates might have have something to do with the S&P500 which has tripled in value since 2009.
And now… the Federal Reserve is hinting at raising interest rates this year.
On the surface, this seems to suggest that they are expecting more growth in the coming years (because remember, theory says that rate hikes slow down growth).
But, considering that U.S. economic growth has been slowing down for the past 30 years, why would the Fed even consider doing this?
Well, it’s because
- Persistently low interest rates tend to cause dangerous imbalances in the economy and asset prices; and
- There has been little material improvement in GDP growth rates
In other words, the potential costs of keeping rates low might (in the Fed’s opinion) outweigh the potential benefits of it.
However, considering that
- The U.S. financial system is more highly leveraged now than even before the 2008 crisis; and
- The stock market has historically crashed after few rate hikes,
… I think the Fed is caught between a rock and a hard place.
It would be economic (and political) suicide to keep raising rates in the face of low growth, and yet if they do nothing, unsustainable pressures would continue building in the U.S. economy.
My Best Guess
This is why, if I had to make a guess, I think the Federal Reserve might raise interest rates some time this year… but if they do so, I wouldn’t expect consecutive rate hikes coming any time soon after that.
Like being stuck in a room filling up with water, the Fed is running out of time and space to breathe.
Personally, I think they are thinking of raising rates because:
- They are trying to signal confidence; and
- There are dangerous bubble-like situations building in various markets
Will it lead to a collapse of stock prices? I don’t know. That will ultimately depend on peoples’ confidence in the Fed to keep things together, because the fundamentals sure aren’t looking too strong.
If the Fed raises rates, we might see a temporary correction in the stock market… but if people believe that the Fed is willing and able to come in to “save the day” in a crisis, we might see the stock market recover and continue making new highs.
In other words, this will mostly be a game of confidence, which incidentally (or perhaps not) is what the term con game means.
Out With A Whimper, Or A Bang?
The bottom line is that even though the U.S. economy looks like it might be recovering minimally, even that has required extreme policies to happen.
Such policies are like steroids. They improve current performance, but come with a future cost. Over time, regular use reduces marginal improvement while the (largely unseen) long term costs accumulate.
Of course, the Federal Reserve projects growth to “normalize” in the coming years, which seems to justify their ongoing policies. At the same time though, Janet Yellen has publicly admitted that her projections are typically wrong.
After more than half a decade of near-zero interest rates and consecutive quantitative (QE) easing programs, growth in the U.S. economy continues to sputter and trend downwards.
What This Means For Us
Let’s face it… no one has a crystal ball to tell us exactly what will happen in the future. Maybe the U.S. will go through a lost decade of their own (like Japan), or maybe they will recover after all. No one knows for sure.
What we do know though, is that pressures continue to build at increasingly unprecedented levels, and if history is any guide, bad things usually follow.
As a trader, this does not affect my regular trading approach too much. But as a long term investor, I definitely don’t want to be exposed to U.S. equity markets unless it’s on the short side.
Does this mean that I expect a market crash soon? No.
A structurally unsound building can stand for a long time before it collapses. So I’m not trying to predict when it will collapse. I’m just saying that I don’t want to be living in it.
The financial world is treading on thin ice, and it will pay for informed investors to tread carefully and wisely.