It looks like the insanely prolonged pregnant pause may finally come to an end.
With the job report that just came out, there is a good possibility that Yellen and the Fed will finally raise rates in a couple weeks.
Of course, if some small hikes occurred as the economy steadied itself over the last six years, there wouldn’t be so much irrational fear of a hike from 0.15% to 0.4%, but there is nothing anyone can do about that now.
All that can be done is to drop an icebreaker. The monetary equivalent of commenting on the weather after an awkward, long silence in a conversation.
Today, we’re not going to go into what the chances of a hike are. It is foolish to take consensus surveys, like Bloomberg‘s recent poll of futures traders that stated there is a 70% chance of a December rate hike.
To us, it is either 100% or 0%. It is a binary decision made behind closed doors, and speculation portrayed as probability doesn’t provide any benefit for us.
Instead, we’re going to take a look at how a rising Fed fund rate heralds the return of risk.
Priced In
We should probably start by spelling out a couple things.
First, there is always risk. However, the six years of the near-zero interest rate policy have made traders complacent.
That changed for a hot second back in August, with the sharp downward spike across the markets. However, by October, the indices returned to levels that have been roughly maintained since February.
Second, buying and selling — along with volume — are expressions of risk tolerance at their most basic levels.
I’m not sure why this isn’t brought up more often, perhaps because it is fairly obvious, but if people are willing to stomach more risk, they buy more equities. If they feel like they’re out on a limb, they sell.
Volatility plays an important role in this when it is elevated, but prices aren’t moving. It shows that there is a balance of people — or at least money — buying and selling in a sort of battle of narratives.
Just using these basic concepts, we can build a simple explanation for why this year has seen overall stagnant prices, even though there have been some dramatic drops and rises.
The market is balanced at a point where there is a collective maximization of risk tolerance. Volatility stays very low most of the time, but when there are any drops in prices, it spikes hard and fast.
As much risk as is currently possible is priced into current prices, and new developments that reduce or increase risk will dictate where prices go from here.
Raising Risk
Raising interest rates raises risk in an economy with anemic growth.
Money becomes more expensive, and it becomes harder for companies to effectively utilize their debt in a way that grows revenues and earnings more than the interest they need to pay.
The ridiculous single-day 1% to 2% swings when the specter of the rate hike appears are melodramatic, to understate it, but they do show that people cannot stomach more risk and a slight headwind from increased interest to already disappointing revenue figures.
Keep in mind this is just for one small hike, too. Gradually, interest rates will have to rise far, far more. To put this in perspective, the average Fed fund rate since 1992 is 2.77%, even with the last six years included.
To get there, 0.25% at a time, will take 10 rate hikes.
The first will be the hardest to deal with, but each hike will raise the perception of risk if it is not counteracted with stronger headline metrics (like GDP growth) than we’ve seen for years.
All of this is kind of absurd when you think about it. Outside of the last six years, the influence of changing interest rates was normal, along with the potential for interest rates to take a bigger bite out of profits.
But we have to deal with the herd mentality of the market. The market shows that they are not pricing in a reversion to the norm, and we have to react accordingly.
What This Means
Rising rates will prompt people to reduce exposure to the riskiest equity positions they hold. They will reposition their investments by shifting towards stable, profitable, even boring stocks.
The return of risk is bad news for many growth-oriented companies out there that use increasingly expensive debt to expand. Investors will demand stronger results or punish the companies with a sell-off.
However, it is going to provide a good, multi-year tailwind for intrinsically less risky stocks. In particular, dividend stocks will see stronger investment inflows.
In many ways, there haven’t been a whole lot of reasons to care which company you invested in as long as they’ve met expectations over the last six years.
That is about to change though, and there is a strong chance that by picking the right dividend stocks now as you re-balance your portfolio for next year, you’ll be able to outperform the broader market while remaining comfortable with your investments.
Peace of mind and profits. You can’t beat that.
