Hawkish Yellen Kills Her “Inner Dove” With Rate Hike
There’s no escaping the Federal Reserve’s decision to raise interest rates.
Rate hikes are pervasive.
They bleed into every financial endeavor — whether it’s a mortgage payment, a credit card purchase or the values of stocks.
Since the Fed plans to ratchet rates up two full percentage points by the end of 2019, it’s time to look under the hood of your portfolio.
Should you be strategically buying and selling based upon the Fed’s new paradigm?
Put simply, yes.
Banks do especially well in higher-interest environments, as their revenue from interest on loans increases.
The Broker/Dealer Index (XBD), an index comprised of highly capitalized companies in the U.S. securities financial industry, is outperforming the S&P 500 by 1.5% so far this year.
But higher interest rates will impact other sectors as well.
I asked my senior analyst, Martin Hutchinson, to do a deeper dive into the Fed’s rate hike.
Chief investment strategist, Wall Street Daily
Question: Martin, the Fed just raised the key interest rate by quarter percent. How far do you think they’ll go?
Martin Hutchinson: It’s interesting. This was the second rate raise in three months — raising the federal funds target rate to 0.75–1%. They have one dissent, from Minneapolis Fed President Neel Kashkari.
They haven’t raised the dot plot of predictions for 2017. They issue predictions every three months as to where they think they’re going to go. So theoretically, we’re due two more raises this year.
Janet Yellen said at the press conference that she would do three more raises in 2018 and another three in 2019 — which sounds a lot. But even when you add it all up, those are all quarter-point raises. So that would make the Fed target range at the end of 2019 2.75–3%. But with inflation at 2% — and it’s running a bit above that at the moment — that’s still pretty loose money.
Gold was up $17 after the Fed’s move, suggesting that they think inflation is coming back.
Question: So what do you make of all this, Hutch?
Martin Hutchinson: My theory is that zero rates and heavy regulation suppressed the economy from 2008–2016. That meant we got very low productivity growth — but it also suppressed inflation. We didn’t get the inflation that you’d have expected from the low interest rates.
Money supply, M2, rose 6% annually throughout that period. But GDP rose only 3–4%. That’s nominal GDP. Real GDP rose about 3%, and then there was a bit of inflation on top of that. And if money supply is rising faster than real GDP, you’d expect inflation to pick up. And my view is that whether it’s the advent of President Trump or the end of zero rates, normality has now returned.
Question: Normality. What do you exactly mean by that?
Martin Hutchinson: In a normal market, loose money causes inflation — and we’ve still got very low interest rates and very loose money. If it does cause inflation, the Fed will have to get more aggressive in raising the rates in order to curb inflation. So if you’ve got inflation and rising federal funds rates, Treasury yields will have to zoom higher. And the budget deficit may go up as well. If President Trump is going to spend some money on the military and build infrastructure, then that’s all going to cause the budget deficit to rise — which also causes interest rates to rise.
Question: So knowing all this, Hutch, are there investment implications?
Martin Hutchinson: Yes, I think so. I think it makes good sense to buy an ETF that’s bearish on the Treasury market. The ProShares UltraShort 20+ Year Treasury ETF (TBT) goes up by twice as much as Treasury bond prices go down — or as yields go up. You can get even more leverage by buying the 2019 $46 calls at $4.50 or better. That means you get not only double leverage from the TBT, but also the options give you additional leverage of about another 2.2 times. You would buy four options for $18 to get the same upside as one share of TBT for $40 at the moment.
So in other words, four options contracts for 100 shares. That makes the options 4.4 times leveraged against the Treasuries (2.2 on the options x 2 on the TBT). 4.4 times leverage is a hell of a lot, so don’t put too much money in this. But you could make out very nicely if my thesis is correct and Treasury bond yields rise.
Question: Excellent, Hutch, as always. Thanks for your time.
Martin Hutchinson: Great pleasure. Thank you very much.
Question: This is Wall Street Daily signing off.
Senior Analyst, Wall Street Daily