Federal Reserve Chair Janet Yellen has finally fulfilled her long-standing commitment. On Wednesday, she raised the federal funds rate to a target range of 0.25 to 0.5 percent. Surprising, isn’t it?
After nearly a decade without a rate hike and seven years of a zero-interest-rate policy (ZIRP), Yellen took the bold step forward. Naturally, she reassured Wall Street, indicating that there was no rush to curtail their liquidity. Here’s a brief excerpt from the FOMC statement:
“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”
Wall Street reacted positively to the term “gradual,” with stock prices soaring. The DOW gained 224 points. Yet the following day, it seemed the market had a change of heart, as the DOW plummeted, closing down 253 points.
The aspiration for a consistently high stock market seems to be dwindling. The duration for which the market remains stable is uncertain, but there’s a possibility that this dream could quickly transform into a nightmare. The commodities market is already witnessing chaos, and the stock market may soon be following suit.
Latent Potential
Whether the Fed opts for incremental increases, reductions, or maintains the current rates, the damage inflicted on the global economy is irreversible. Just glancing at various asset classes elicits concern over their disfigured state.
Consider junk bonds. They resemble a circus sideshow spectacle, scarred with pins and tattoos. Observers can’t help but gasp in disbelief but find it hard to look away.
Driven by misguided Fed policy over the past seven years, investors poured into non-investment grade bonds in their quest for yield. As David Stockman points out, outstanding junk bonds surged from $700 billion in 2007 to $1.7 trillion by October 2015. This marks a staggering 242 percent rise in high-risk assets, fueled by the effects of ZIRP.
As junk bonds became more popular, their spreads tightened. Despite being characterized as high credit risk, they appeared lower risk to investors. However, just because spreads narrowed doesn’t mean risk evaporated; rather, it accumulated and later manifested at the most unfortunate time.
In recent months, the selling of junk bonds surged, peaking with a quick selloff last Friday. This could have been in response to the Fed’s upcoming rate hike or the realization that oil prices may not rebound soon, leaving shale drillers struggling.
Looking ahead, junk bonds could trigger a more extensive financial crisis. This upheaval is a harbinger of what awaits in the era following ZIRP.
Life After ZIRP
Life after ZIRP—this present moment—will mirror life before ZIRP in many ways. The sun will continue to set and rise, flowers will bloom and wither, and new life will emerge in spring.
Yet, there are significant changes. The landscape we’ve known for the last 35 years – characterized by steadily declining interest rates easing debt burdens – has come to an end. The Fed’s recent rate increase might mark the beginning of a reversal of this long-standing credit trend.
As credit becomes more expensive, asset prices are likely to drop. Even if interest rates do not climb drastically, asset prices could still decline. In this unpredictable realm of fiat currency, anything is possible.
Strangely enough, credit may not become immediately more costly. Yet, due to the extreme overvaluation of assets and the economy’s overwhelming debt, asset prices could still face deflation. This means homeowners and other borrowers could find themselves underwater, all while interest rates remain low.
The crucial takeaway is that financial markets have been so distorted over the last seven years that ZIRP ceased to be beneficial. Markets became reliant on cheap credit, and as it diminishes—even slightly—the impact will endure.
The repercussions of decades of manipulation cannot be undone in just a year or two. Life after ZIRP will be harsher and less forgiving for many years ahead.
Best wishes,
MN Gordon
for Economic Prism
