OK, not really. Winter’s already here.
But, for the investing world, things are starting to get a lot more chilly and scary. The storm clouds are rolling in.
After seven years of holding short-term interest rates at roughly 0%, with no hikes for nearly a decade, the U.S. Federal Reserve Bank has officially begun to tighten up its lending policy again, slowly raising the interest rate it charges banks and other financial institutions to borrow from it.
On the surface, this is great news.
It means that the economy is finally showing signs of strength again, a full six years since the lows of the 2008 financial crisis. And it means that the unprecedented steps that the Fed took to keep us from the brink of financial ruin can finally be rolled back.
We’re on solid ground again. The economy is able to sustain itself. The Fed can get back to normal.
We should all be happy (and we are).
For the markets, though, this news comes with some dark clouds. There are reasons to be worried.
After years of life in a near-zero interest rate environment, no one is really sure what’s going to happen now that rates are rising again. Will the bull market stumble? Will lending dry up? Will the economy slip back into another recession?
(Yes, no and probably, but not for a while.)
And what about all of those investors and money managers out there who only know life with zero interest rates? What will they do with more normal policies from the Fed? Will they freak out?
There’s a lot we don’t know.
But this is happening, no matter what we think or want.
First, let me explain this whole thing simply.
The Fed lends money to banks, and banks lend money to each other based on the benchmark rates that the Fed establishes. When the Fed rate is low, savings rates are low. That’s because banks aren’t paying much in interest on those savings. There are better things to do with your money.
When savings rates are low, people put more money in higher risk stocks instead of savings. Make sense, otherwise their returns will suck. (Sorry banks, but a savings account that pays you less than 1% APR sucks. It’s a waste of time, and everybody knows it. Inflation is 2%. Do the math.)
But when savings rates are high (7%+), people put money in their savings account because it’s safer (it really is).
That’s why people say, “when interest rates go up, stocks go down.”
Oh my god!
So where are we now? The Fed Rate has been near 0% for six years (actually, the target is 0%-0.25%). This is (and has been) ALMOST FREE MONEY for banks … for years. And this has been driving stock market growth ever since 2008.
The Fed’s first step in normalization was to increase the target rate from 0% to 0.25%-0.50%. Not a big move.
They SHOULD raise the rate to 0.5% or even 2%. In that case, nobody will say, “Oh, now I should move out of the stock market and get 2% savings rates.” That isn’t really worth it either.
But we don’t know how this is going to go, or what they’re going to do.
And, by the way, the Fed only raises rates when every indicator suggests that companies are growing at a fast rate. So they have a good reason to do this.
The promise of easy money
If you’ve ever watched TV in the Washington, D.C. metro area you probably know who Matthew Lesko is.
He’s the guy who dresses up in a purple suit with yellow question marks all over it (I’m still not sure why) with a bow tie and films infomercials in front of the U.S. Capitol building about how you can get free money from the Federal government to start a small business, pay your taxes, and a long list of other things.
Whatever you needed money for, the government has a program to help you out. You didn’t really have to do anything to get it, just ask.
He would stand there on the Mall, frantically waving his arms around and yelling about FREE MONEY!, listing off all of the different government programs he had found that regular people could take advantage of.
(I last saw one of his ads around 2005, but he may well still be going with them. I’m not sure. He did used to drive around in a car covered with question marks, though.)
All of this was to sell the books he wrote to help people find and apply for these grants. Now he sells access to an online database of government grant programs.
Anyway, his whole message was about free money. From the government.
What a deal!
And that’s what the Fed has been offering to the market ever since the last recession.
The stock market has been on a tear for the better part of seven years—up more than 170% since the March 2009 bottom—fueled by a lot of deep-pocketed investors as well as that promise I talked about earlier of free money from the government.
When interest rates are low, companies can borrow on the cheap to build their businesses or invest in other things. Their debt costs—“cost of capital”—go way down and they’re able to focus on growing their revenues.
It’s a great deal for them, and for investors.
But when this easy money goes away, thing should naturally slow down, if not fall into the red entirely. Cheap money is an addiction. Take away the goods, and things freak out a little bit.