Interest Rate Conundrum Seems Well Beyond the Fed’s Pay Grade

In recent months the Federal Reserve (the Fed) started a marketing (if not real) campaign to raise interest rate levels to more “normal” levels, ostensibly because the US and global economy has shown meaningful signs of “recovery and stability.” The real reason is more likely to bail out the global financial system, including banks, insurance companies and pension funds that need higher rates to insure their continuing solvency and stability. Another more plausible reason is to give the Fed breathing room to lower rates again when the economy starts rolling into a long-overdue recession.

The most compelling evidence for an economic recovery has been the meteoric rise of the US stock market since 2009, and that, for most realistic observers, is the direct result of a relentless campaign of historically low interest rates and unprecedented money printing by global central banks including the Fed. Going forward, many experts believe that the continued rise of the stock market will require leadership from financial sector equities, which need higher interest rates to propel their profitability. Therein lies the problem: the real economy and the broader financial markets need low interest rates for stability and improvement, but the financial sector needs higher rates.

Even the financial sector itself is caught in a love-hate relationship with low/high interest rates. Its profitability requires strong and steady loan growth, which requires strong economic growth, which requires low interest rates. Loan profitability, however, requires, greater profit margins, i.e., a greater difference between long and short interest rates (aka spreads), which require a steeper yield curve resulting from higher interest rates.

As if that situation isn’t bad enough, the Fed has been walking an interest rate tightrope for years because of their effect on the US dollar. Higher interest rates and a stronger dollar have the potential to throw us into a recession as it makes our exports less price competitive in the global market, has the potential to crash commodity prices (which are already near all time lows), and could cause a debt debacle in the emerging markets that loaded up on $9 Trillion in dollar-denominated debt after the financial crisis! A stronger dollar makes that debt more expensive to repay.

On the other hand, keeping interest rates low poses an existential threat to the Fed and global central banks (i.e., the keepers of global fiat/paper currencies) and low interest rates could cause them to lose control of the financial markets as participants begin to favor gold and other precious metals (for which they have minimal control) over paper currencies (which is their exclusive domain).

Three large banks, JP Morgan Chase, Citigroup, and Wells Fargo, recently reported decent Q2 financial results, but it would seem the market was disappointed and unimpressed and responded with a modest sell-off in financial equities.

What’s the correct next step? Does the Fed continue its charade of talking up interest rates in the hope of propelling the financial sector even at the risk of tanking the global economy? What to do? What to do? Clearly no one, least of all the Fed, seems to have a clue!