FOMC: The Risk of Higher Interest Rates ProShares UltraShort Lehman 20+ Yr(ETF) (NYSEARCA:TBT)

The FOMC has everything they need to raise interest rates, but they are not expected to do it.  Their mandates are for full employment and moderate inflation, both of which currently exist.  Although labor force participation and wage growth can be used in contrary arguments, full employment exists according to fed officials, and their target of 2% inflation does too.

I remember the day when CORE CPI mattered more than CPI because it provided a measure of inflation that was less volatile after removing food and energy components, which can cause wild swings from time to time.  That is exactly what is happening now. 

The July reading showed us that CPI was up only 0.8% Y/Y (due to oil), which is lower than the 2% targeted by the FOMC, but when we remove food and energy, the CORE CPI is up 2.2% on an adjusted basis.  That makes inflation right in line with their target too.

So why isn't the FOMC raising rates?

Ahead of Brexit, they said it was nervousness, but in the last meeting they were rather upbeat on the economy for the first time.  Will that open the door to higher rates given the satisfied mandates?  Wall Street doesn't seem to think so, and recently Yellen has been humming to their tune.  ProShares UltraShort Lehman 20+ Yr(ETF) (NYSEARCA:TBT) is near an all time low!

There is another way of looking at this though. 

Leading by example, the United States is a debtor nation; growth fostered by debt has been the policy of choice for years, and that does not only apply to governments.  With debt levels prices on extremely low rates we all have been encouraged to assume added risks in favor of more affordable payment options.

When we consider housing and the lack of wage growth though, this has influenced risk-taking to much higher levels than anyone thinks.  Certainly, people may be able to afford the payment, but can they afford the risk? 

Interest rates and prices are inversely related, and interest rates are near all time lows and the FOMC already has enough ammunition to raise rates, but that inverse relationship can wreak havoc.  If rates are at all time lows, that means the influence rates have on prices is at an all time high.

Furthermore, it means higher rates would have negative influences on prices.

Assume that you had $100K to put down on a home that was $500K in today's market (fair value).  You did this at a time when rates were low, so affordability looked great.  You could buy a higher priced home than you thought, but prices also increased as rates dropped, so in reality you would have probably been able to afford the same home at a lower price with a higher rate too.  Remember, although the real estate market is not as fluid as the stock market, adjustments absolutely happen.

Still, you own this home, you have $100K invested, and now assume rates go up by 1%.

Using any mortgage calculator, you can see that you would not have been able to afford your home at that higher rate due to the higher monthly payment, and that goes for everyone.  That higher payment makes it less affordable, that means fewer people are able to buy it, and that lowered demand is why real estate prices adjust.  In this example, at a 1% higher rate the price of that home would need to decline to about $450K for people who earn as much as you to afford the same home.  For your peers to afford the same home they would need it to be priced 10% less if interest rates increase by 1%.

Okay, 10% does not sound bad, you might think you can live with it, but think about this more clearly.  10% of the $500K value is $50K, and your investment was $100K, so the real net loss would be 50%.

This example is intended to demonstrate the risks of higher interest rates, and why the FOMC is so reluctant to raise rates.  Not to mention the Government's payment burden if rates increase too, the inverse relationship between yield and prices will cause investors to experience massive financial losses if rates go up, and that huge risk looms large.

If they raise rates and asset prices decline modestly, the real financial losses based on the down payment amounts for the debt will actually be massive.

To say that they are afraid to raise rates would be an understatement.  Given our debtor nation policies such a move could cause wealth destruction on a scale comparable to the financial crisis if not handled properly.  That's one of the reasons they have pointed to lower CPI instead of CORE even though CORE CPI is a much better measure.

 The FOMC is using every reason they can to NOT raise rates.  They would love higher real inflation rates, but that does not come without real wage growth, so there's the corner they have been painted into.  Not to mention, stimulus money has created an asset bubble by inflating prices to levels that are comparably well beyond far value.  If rates go up and stimulus stops, this economic is going to react like a drug addict on his first day of recovery.

  1. Domestic stimulus has already stopped.
  2. And they already have what they need to raise rates.
  3. But no one thinks they will.