Last week, several Fed officials suggested they might raise interest rates at the Fed meeting scheduled for June 14 and 15.
The dollar strengthened and the gold price declined following their statement, suggesting the “Currency Cold War” of the last few years may be ending.
However, the likely 0.25% rate increase is nowhere near enough to end the Currency Cold War, or even reduce the chance of a hot war.
So long as interest rates remain below the inflation rate, the financial system is unstable and heading for a crash.
Rates Not Rising Enough
Another Fed rate rise in June will take the federal funds target range to 0.50% to 0.75%.
However, inflation is still around 2% (the “core” consumer price index was up 2.1% in the 12 months to May). Hence real interest rates are still below negative 1%.
What’s more, the Fed is unlikely to undertake the four rate rises that were forecast at the beginning of the year. At most, the Fed is likely to raise rates just one more time at the four remaining Federal Open Market Committee meetings in 2016.
At that rate of progress, with rates rising at 0.50% per annum, the federal funds rate won’t reach a target rate of 2% to 2.25%, level with inflation, until the middle of 2019.
Given that the Bank of England, the European Central Bank (ECB), and the Bank of Japan (BoJ) are pursuing more stimulative policies, the Currency Cold War will continue, or be replaced with something worse.
Negative real interest rates cause the amount of free money sloshing around to increase exponentially (because borrowing is so cheap), especially when money is injected into the system, as the ECB and the BoJ are doing. That, in turn, leads to wild currency fluctuations, not the milder, slower moves that occur when money is expensive and speculators are scarce.
We now know the picture won’t change with the arrival of a new President in January. Hillary Clinton supports Janet Yellen and her easy-money policies, while Donald Trump has now confessed himself a “low interest rate guy” – a pity nobody asked him this question earlier in the primary process, when it might have made a difference.
If nothing disrupts the U.S. economy, the achingly slow interest rate rises will continue.
Trouble Ahead
In practice, disruption is likely to arrive well before 2019.
The current low-rate policy, which has been in effect since 2008, brought about a massive flood of “malinvestment.” These misguided investments will have to be washed out of the economy before healthy growth can resume.
Think of Valeant Pharmaceuticals International Inc (NYSE:VRX), the drug company whose business model was to buy smaller companies, jack up the prices of their drugs by 100% to 500%, and hope the drug buyers wouldn’t notice. That’s $30 billion of wobbly debt, right there.
Then there are the energy master limited partnerships like Breitbart Energy Partners LP (NASDAQ:BBEP) that bought assets when oil was $100 per barrel and hoped the derivatives market would take away their oil price risk. It didn’t.
Then there are the gigantic hotel projects, several times the size of the market, whose empty silence makes you feel like a Pharaoh buried under a pyramid when you visit.
Finally, there’s the high-tech taxi service valued at $50 billion – maybe healthy, but massively inflated in value.
The unhealthiness of the current economy is demonstrated by productivity growth, averaging only 0.6% annually over the last five years and negative in the last quarter, compared to an average of 2% annually before 2007. Frankly, it’s unlikely the current economy can continue until 2019 without a massive financial crisis, however hard the Fed may attempt to avoid one.
At the point, the Fed and other central banks may come to their senses, ending the Currency Cold War. Unfortunately, they’ll most likely push us into negative interest rates, intensifying it – though that would give us some wonderful profit opportunities, if we’re nimble!
Another possibility is that continued stimulus will be accompanied by a true attempt to push the dollar down, possibly accompanied by Trumpean tariffs. At that point, the Currency Cold War will turn hot.
But with my Currency and Capital new Hillary Hedge (or Trump Trade) of a long-term gold call option, we’re ready for that, too.
Good investing.