A Fed Rate Hike and a Possible Recession

Thursday, December 3, 2015 was a rocky day in the financial markets. Things just keep getting more bizarre.

The euro skyrocketed upwards on news that the ECB cut its deposit rate down .1%. It now stands at -0.3%. In case you are wondering, that is a negative sign. But in our crazy world of negative interest rates, investors were actually expecting a bigger cut. They were also hoping for more money creation.

The euro was up a lot, the dollar was down, stocks were down, and interest rates were up. The yield on the 10-year Treasury rose substantially to 2.33%, which was about a 7% increase over the previous day’s close.

Meanwhile, Janet Yellen was testifying in front of Congress, as investors prepare for a likely rate hike in a couple of weeks.

It will be a token rate hike of no more than 0.25%. It is also not that big of a deal because it is not dictating monetary policy. The Fed could start another round of QE while raising rates at the same time.

The only rate the Fed can directly control at this point is the rate it pays banks for their reserves. This rate has been set at 0.25% for the last 7 years. If the Fed hikes this rate as expected, the banks can get some more “free” money. It will matter in one sense. Banks will curtail lending on the margin even more.

The Fed is likely going to trigger a recession. Fed officials may know this and they don’t want to take the blame for it. But it is also hard for them to back out of their promise to raise rates at this point.

Every time the Fed is supposed to raise rates, an excuse is made up to delay it. Falling stock markets, trouble in China, etc. are always there for an excuse.

Maybe the Fed will surprise everyone and come up with another excuse to delay raising its key rate. With the 10-year yield spiking up, maybe the Fed will not raise rates by using the excuse that market rates are going up. Would this make any sense? In today’s world, it might make enough sense for them to try it.

I am not convinced that a Fed rate hike will lead to higher market rates down the road. It has already been priced in to a large degree.

We must remember that the Fed had three big rounds of so-called quantitative easing. It ended its biggest round – QE3 – just over a year ago. The monetary base has been relatively flat since then. And now the Fed is supposed to raise the rate it pays on bank reserves, thus reducing loans on the margin.

If you follow the Austrian Business Cycle Theory – or just common sense and general logic – then it is not hard to imagine that we may see a significant economic downturn. The Fed and the government have misallocated resources on a grand scale over the last 7 years. They never let the previous misallocations fully adjust. These misallocations are going to be exposed and we will be in for another correction.

If that happens as I expect, then market interest rates will likely go down as investors seek safety (in their eyes).

If you are not prepared for a recession, you should get prepared. The timing is virtually impossible to predict, but there are a lot of signs pointing in that direction right now.

Cash will be king. When the Fed starts inflating again, that status will move to gold.