It’s OK to be Confused

“If you’re not confused [on the economy], you don’t understand things very well.” – Charlie Munger

The Fed is holding policy meetings over a couple of days in the coming week and it’s got investors on edge. Many believe this will be the time they finally raise the Fed Funds Rate, just shy of a decade since the last time they did so.

No one knows for sure if they will or won’t, but it’s worth considering the implications on the markets since interest rates play such a vital role in capital allocation decisions. Robert Shiller, writing for The Upshot at the New York Times, recently discussed some of the different ways this could play out:

First, logic tells us that if short-term Treasury rates rise, low-risk Treasury bills may become more attractive in comparison with riskier alternatives like stocks. That suggests that the stock market should weaken because people will become even more wary than they may be right now about share prices, which have tripled since 2009. Home prices should weaken too, because rising interest rates can be expected to make mortgages more expensive. In other words, this line of thinking is quite negative about the general effect of a rate increase on market prices.

There is another way to look at this, though. If the Fed raises rates in December it could be seen as good news because the Fed wouldn’t take that action unless it viewed the economy as relatively strong. That could buoy market prices.

This approach immediately leads to further complications. Good news about the economy might be bad news about inflation, which tends to rise when economic growth picks up. On the other hand, if inflation rises, even if the Fed raises rates slightly, the real, or inflation-corrected, interest rate might actually be lower, not higher. Confused? That is understandable: This line of thinking might lead us into a muddle very quickly. But don’t be surprised if you hear circuitous commentary like this in the weeks ahead.

To sum up — higher interest rates spell trouble for risk assets, but rates may be rising because of positives in the economic back-drop, but higher inflation from improved economic growth could actually lead to lower real rates, then there’s the matter of figuring out what’s already priced into this move and oh no, I’ve gone cross-eyed.

The problem is that markets don’t exist in a vacuum. Sometimes it’s the absolute levels that matter, but most of the time things move because of how the news or different datapoints are viewed on a relative basis. Investors aren’t just paying attention to the news, but they’re looking at how other investors are reacting or positioned to that news. Financial markets aren’t conditional. There’s no such thing as, ‘If A happens then B will automatically follow.’ It’s never going to be that easy.

One thing is for sure — we will see many investors overreact to this news, whether the Fed raises rates or not. And regardless of the short-term outcomes, it’s going to take some time to truly understand the ramifications and unintended consequences of these unprecedented monetary policies.

If nothing else, markets are inherently cyclical. Unfortunately, every cycle looks different than the last. The current iteration is perhaps more complicated than any we’ve seen in recent memory. There are far more moving pieces involved here than just a single interest rate.

It’s OK to be confused about the potential outcomes.

Source:
Don’t Assume a Fed Action Will Move the Market

Further Reading:
Uncharted Territory in the Fed Funds Rate Cycle