US Fed: Go Knock Yourself Out, Chicken Little

Following this week’s Federal Reserve meeting, Chairman Janet Yellen should have simply announced a 0.25% rate hike for mid-September. She should have accompanied this announcement by yelling out the following statement, “Now go knock yourself out, Chicken Little.”

The fact is that all of America has now become a nation of Fed watchers. Everyone with more than a few bucks to invest is obsessed with U.S. interest rate policy, fearing that a rising rate environment will wreak havoc on the markets.

This outlook may be overstated, however. The reality is that the initiation of a rising rate cycle might actually be good for the markets. This is especially true when it comes to investor psychology.

The Fed Will Remain in Control

First of all, a rate increase of one quarter of one percentage point does not automatically signal a consistent process of rising rates.

One would expect the economists at the Fed to keep a close eye on the economy and the markets. If an initial rate hike were to cause a slowdown in economic activity or a spike in unemployment, the Fed would in all likelihood hold off on subsequent hikes.

If the U.S. economy were to slow down significantly after one or two rate hikes, the U.S. central bank might even reverse course and lower rates, undoing what it did in the first place.

Flatten the Curve

Another key factor to consider is that a rate hike in the absence of inflation may not have the impact on rates that one might expect.

The Fed has control over short-term rates only. It is the markets that set long-term rates. The markets might view Fed tightening in the absence of inflation as a net positive for long-term rates.

This would cause the yield curve to flatten rather than steepen. That is, long-term rates would be subjected to downward pressure even in the face of rising short-term rates.

Even after factoring in higher financing costs for longer-term bond portfolios, the increase at the long end of the curve might be significantly lower than at the short. And folks, the hike we’re talking about is only 25 basis points! This is hardly a cataclysm.

If – and this is a big if – the yield on the ten-year Treasury were to rise in lock step with a 25 basis point rise in short-term rates, a bond portfolio with a duration of 10 years would experience a decline in value of around 2.5%.

Not the end of the world, especially since the ten-year yield is not likely to rise the full 25 basis points when inflation is not a threat. But then there would be other things to consider.

A Fire Sale on Mortgages and Corporate Bonds

For example, perceptions of a rising rate environment would foster a mortgage boom as homebuyers scramble to take advantage of rates before they go much higher.

Such an outcome would promote accelerations in the rates of new house construction and renovations of existing homes – key drivers of overall economic activity.

The same might be true of corporate borrowers looking to build war chests for acquisitions and expansions – also key drivers of economic activity.

A Flood of Foreign Money

Investor psychology plays an even more significant role when looking at capital flows into and out of fixed income and markets.

A rate hike by the Fed, coming as it would at a time when the ECB and Chinese Central Bank are pumping money into their respective economies, would help further solidify the dollar’s role as the world’s number one store of financial value.

By the same token, a rate hike will signal that the U.S. economy has turned a corner. It stands alone as the first major economy since the crash of 2008 to return to a normal monetary framework and to stand on its own two feet.

These factors will make U.S. financial assets all the more attractive, particularly to foreign investors who are dealing with significant challenges in their home markets.

Sell on the Rumor, Buy on the News

To be sure, there is no certainty what a rate hike will augur in a period of macroeconomic bliss. Much could go wrong. For example, inflation could flare up, making successive rate hikes mandatory and setting the stage for Fed action aimed at slowing economic activity overall.

By the same token, a full-fledged break in the Euro could render the U.S. dollar artificially strong and consequently non-competitive in the world market.

But right now, inflation is nowhere in sight and the Euro is trundling along.

The newly minted nation of Fed watchers would do well to recall one of the oldest adages in finance, which says, “Buy on the rumor, sell on the news.” The current monetary situation might just turn this upside down: “Sell on the rumor, buy on the news.”