Fed Chairman Yellen says the Fed didn’t raise interest rates last Thursday primarily because of low inflation and turbulence overseas (i.e. China).
But behind what she says, there’s a heck of a lot more going on that she would never say:
- She realizes the U.S. economy is a lot weaker than the Fed is letting on.
- She’s worried about making the financial and political turmoil in Europe and the Middle East even worse, with major spillover effects on the U.S.
- She doesn’t want to make the U.S. dollar even stronger — and the U.S. even less competitive — especially on the heels of the greenback’s biggest winning streak since 1984.
- She’s aware of the fact that, as rates rise, the interest costs will rise for heavily indebted governments in Western Europe, Japan and the U.S., leading to a new, larger sovereign-debt crisis.
Plus, most important, she’s terrified of the …
Two Elephants in the Room
The first elephant is the pervasive impact on society of over six long years of zero interest rates. Even during World War II — the greatest existential threat to our nation since Independence — the Fed didn’t push rates down that far or hold them down for that long. The result has been a massive shift in the psychology, the strategy and the portfolios of millions of investors, corporations and consumers:
Investors who have shifted, en masse, from safe-haven investments to risk assets …
Businesses who have borrowed heavily by floating trillions of dollars in new junk bonds, and …
Consumers who have drained their savings to new lows and favored floating-rate debts like never before.
All because of zero interest rates! All creating rows of dominoes that are potentially very vulnerable to any rate hike!
The second elephant in the room is the massive amounts of new funny money the Fed has pumped into our economy since September 2008 … and the speculative bubbles it has created.
Since 2008, we’ve seen the emergence of a $2.2 trillion bubble in small-cap stocks, a $1.81 trillion bubble in domestic junk bonds, and a series of even larger bubbles in other debts globally — all extremely vulnerable to higher interest rates.
I’ll get to the bubbles in upcoming Money and Markets editions. Today, let me first show you — graphically and vividly — exactly where they’re coming from.
This chart says it all. –>
Throughout history, the U.S. Federal Reserve almost always expanded the nation’s monetary base (bank reserves and money in circulation) at a relatively steady pace.
Then, suddenly, in September 2008, the Fed began running its money printing presses like never before.
What triggered such an incredibly massive and abrupt policy change at the Fed?
Answer: The single most shocking financial failure of our era — Lehman Brothers.
But even as Fed governors sought to save the world from collapse, they discovered three things:
First, they discovered that lowering their official interest rates to zero percent, although extreme, was not enough. “What good was making money cheap,” they said, “if there was no money being borrowed?” (That’s when they decided to open the money floodgates.)
Second, the whole concept of “printing money” sounded too much like what Germany did after World War I, creating massive inflation. Thus, to avoid sounding like money madmen, they coined a more erudite phrase — “quantitative easing” or “QE.”
Third, they realized that just one round of QE still wasn’t enough. American consumers, investors and businesses got so addicted to all the new Fed funny money, they needed new shots in the arm year after year. As a result, the Fed embarked on three major rounds of QE, called QE1, QE2 and QE3.
Clearly, the day that Lehman Brothers failed, the Federal Reserve — and the entire financial world as we know it — changed dramatically.
How dramatically? Consider these facts:
Fact #1. Just from Sept. 10, 2008, through March 10, 2010, the U.S. Federal Reserve increased the nation’s monetary base from $850 billion to $2.1 trillion — an insane increase of 2.5 times in just 18 months. It was, by far, the greatest monetary expansion in U.S. history.
Fact #2. Before the Lehman Brothers collapse, it had taken the Fed a total 5,012 days — 13 years and 8 months — to double the monetary base. In contrast, after the Lehman Brothers collapse, it took the Fed governors only 112 days to do so. In other words, they accelerated the pace of bank reserve expansion by a factor of 45 to 1.
Fact #3. Even in the most extreme circumstances of recent history, the Fed had never pumped in anything close to that much money in such a short period of time.
For example, before the turn of the millennium, the Fed scrambled to provide liquidity to U.S. banks to ward off a feared Y2K catastrophe, bumping up bank reserves from $557 billion on Oct. 6, 1999, to $630 billion by Jan. 12, 2000.
At the time, that sudden increase was considered unprecedented — a $73 billion in just three months. In contrast, from September 2008 through September 2015, the Fed increased the monetary base by $3,225 billion or 44 times more.
Similarly, in the days following the 9/11 terrorist attacks, the Fed had rushed to flood the banks with liquid funds, adding $40 billion through Sept. 19, 2001. But the Fed’s post-Lehman flood of money has been nearly 81 times larger.
Fact #4. After the Y2K and 9/11 crises had passed, the Fed promptly reversed its money infusions and sopped up the extra liquidity from the banking system.
But in the six-plus years since the Lehman Brothers collapse, the Fed has done nothing of the kind …
And it’s this three-letter word that contains the secret to our entire future — not only for the United States, but for the entire global economy.
As you can see from the chart, the Fed reversed its Y2K and 9/11 money pumping episodes quickly and completely. But it has not yet begun to reverse its history-smashing money-printing binge of the past seven years.
This raises major, heretofore unanswered
questions for all investors in all asset classes …
When the Fed does raise rates, how will it impact the psychology and strategies of investors, businesses and consumers?
What will happen as the Fed begins to reverse the massive money-printing of recent years?
Which sectors and markets are the most vulnerable?
For the answer to the last question, the first place to look will be in all those sectors that have gotten the biggest influx of super-cheap money since 2008 … and are bound to suffer the most from any outflows. They include …
- Speculative bubbles in major world commodities, most of which have already burst.
- Speculative bubbles in BRIC countries, three largest of which — Brazil, Russia and China — have also already burst.
- And next, speculative bubbles in small caps, junk bonds and other debts that are only now beginning to show initial signs of strain.
We will tell you more about these — and how to get out of their way — in the weeks ahead.
In the meantime, be sure to keep your investment portfolio as safe as possible, with plenty of cash and a moderate dose of hedging.
Good luck and God bless!