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Why the Federal Reserve May Keep Rates Low as Inflation Rises

After the “Great Recession”, US households carried a lot of debt and were hurting economically from that burden.  One of the reasons the Federal Reserve (“Fed”) decided to initiate its quantitative easing program was to ease this burden on households while at the same time propping up the general economy.  Households benefited by refinancing their debt at lower interest rates.  The end result was a reduction in debt, thus allowing households to save more.  Europe is trying to achieve the same goal by creating negative interest rates – especially for the highly indebted countries of Portugal, Italy, Greece and Spain – the so-called PIGS.  So is the Fed going to do the same thing in the United States?  We think so, but with a different approach and in conjunction with the US Treasury.

The Fed will not utilize negative interest rates like Europe, but we do expect they will keep rates artificially low for an extended period, even as inflation rises above its 2% target.  It may raise interest rates a bit, but it won’t be enough to tamp down inflation.  This begs the question “why won’t the Fed raise interest rates more aggressively?”  As you can see in the chart below, most of the US debt matures in less than five years.  If the Fed raises interest rates aggressively now, the debt expense for the federal government would increase significantly.  So, how is this problem alleviated?  Shortly after his meeting with Janet Yellen, the new Treasury Secretary, Steve Mnuchin, talked about issuing 50 year and 100 year bonds.  The Trump administration is considering locking in these current low interest rates on a long-term basis, just like homeowners did after the Great Recession.  This makes a lot of sense for the government.  Once debt has been moved to these longer-term bonds, the Fed can then start raising short term interest rates to fight the inflation it is now causing by keeping rates low.  Soon after those bonds are issued, risk assets will start to be repriced as the Fed has room to raise interest rates more aggressively.

us-treasury-by-debt

What does this mean for your portfolio?

THOR follows a structured, disciplined investment approach based on fundamentals and we do not want to end up being the last person at the punch bowl.  Every financial crisis since 1987 has, in a major way, been created by the Fed (i.e., easy money policy in 1999 because of the fear of the Y2K computer bug; not raising lending standards in 2006, thus allowing the sub-prime mortgage market to get out of hand).  The Fed’s inaction relative to interest rates has the potential to create yet another financial problem.  The real risk to your portfolios is rising inflation if the Fed is late to raise interest rates.  In our opinion, it is imperative to have a portion of your portfolio in hard assets (commodities, energy, etc.) as a protection against inflation.