For years – since interest rates hit lows after the global economic crisis in 2008-2009 – investors have been waiting for interest rates to rise.
Periodic murmurings by the Federal Reserve, the American central bank, about interest rates have been enough to send markets into a tailspin (remember December 2015?).
But if you’re still waiting for the Federal Reserve to finally raise interest rates back to a ‘normal’ level, you’re in for a long wait.
That’s because despite the latest hike in June [most recently], to a target range of 1 to 1.25 percent, there aren’t going to be many more interest rate hikes in this economic cycle.
Over the past 40 years, the Fed funds rate has averaged 5.3 percent. Over 30 years, the average is 3.65 percent. But it could be another decade before we see those kinds of Fed rates.
This could have profound implications for every investment decision you make.
In December 2008, in the depths of the global economic crisis, and as the U.S. slipped into recession, the Federal Reserve under Chairman Ben Bernanke lowered the key Fed Funds Target rate to zero percent.
(The Fed funds rate is one of the most-watched interest rates in the world. Specifically, this is the interest rate that banks charge each other for overnight loans. It is a set by the Fed as a “range”. When people talk about “the Fed raising interest rates,” they’re really talking about the Fed funds rate.)
It wasn’t until December 2015, seven years later, that Fed head Janet Yellen raised the benchmark target range by 0.25 percent.
Since then, the Fed has implemented three further 0.25 percent rate rises (the latest being earlier this month) against a backdrop of falling unemployment (now at 4.7 percent, down from 5 percent in December 2015 when the first rate hike was made), and slowly rising economic growth.
But there’s every reason to believe that we are nearing the end of this tightening cycle.
Take a look at the chart below. It shows the market-implied future Fed funds rate from today, to three years in the future. These rates are what the market currently predicts the Fed funds rates will be in the future.
The market is telling you that three years from today, the implied Fed target rate will only be 1.68 percent.
The current upper bound is 1.25 percent. So that means the market is only expecting two further 0.25 percent rate hikes from the Fed in the next three years (i.e. from 1.25 percent to 1.75 percent).
Why are traders so sceptical on much more in the way of interest rate rises? Well, there are a few possible reasons.
Firstly, take a look at what’s happened to inflation expectations. The chart below shows the level of inflation that consumers expect over the coming 12 months.
In 2013, it was between 3 and 3.5 percent. It bottomed out in late 2015 at around 2.5 percent before rising sharply in the way of Donald Trump’s electoral victory.
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But inflation expectations have now plummeted sharply so far this year.
Inflation expectations are hugely important. If a consumer doesn’t believe that prices will rise in the future, he has less inclination to spend now (since whatever he’s buying won’t get more expensive). It also means that holding cash is an acceptable alternative. Inflation eats away at the value of cash, so if inflation expectations are low, again the consumer is happy to hold on to it.
Looking at other measures of inflation, we see a similar trend emerging. Personal Consumption Expenditure (PCE) and the Consumer Price Index (CPI) are two primary measures of inflation. As the chart below shows, these have both fallen this year.
Another measure of future inflation is the 5-year breakeven inflation rate. This is the annual rate of inflation expected over the course of five years, starting five years from now.
It’s derived from inflation swaps and inflation-linked bond prices. Likewise this figure has fallen so far this year.
Nearing the end of the economic cycle
I mentioned the economic cycle earlier on. It’s worth noting that we are far closer to the end of this economic cycle than most investors seem to realise.
Every economic cycle has four main stages: expansion, peak, contraction and trough. Right now, we are at the latter stages of the expansion phase.
The National Bureau of Economic Research (NBER) is the definitive source on cycles dating back to 1854.
In the 33 cycles from 1854 to 2009, the average time between each cycle peak was just over 65 months.
In the 11 cycles since 1945, the average peak-to-peak duration was 68.5 months.
The last peak recorded by the NBER was in December of 2007. That’s 114 months ago… It’s currently the second longest peak-to-peak on record.
History suggests that there is not much more interest rate tightening ahead of us before the U.S. slips back into an increasingly overdue recession.
The potential saving grace
The key statistic to watch over the next few months is wages, specifically wage growth.
The sluggishness of the post-global economic crisis recovery has been most visibly demonstrated by a very slow recovery in wage growth.
At the end of 2016/early 2017 we saw annual wage inflation approach 3 percent, but since then it has declined back down to 2.5 percent.
If wages growth increases, it’s likely to fuel inflation along with economic growth – which in turn will support faster interest rate hikes.
If not, then inflation and inflation expectations could continue to fall, and rate hikes will be further postponed.
What to buy?
If interest rates are going to remain lower than expected for longer, then it makes sense to overweight income paying financial assets… that means bonds, dividend stocks, real estate investment trusts (REITs) and preferred stock.
We’ll be talking a lot more about this in coming weeks.