So do you want rates to rise or don’t you?

Written June 4th, 2013

I’m confused. If zero rates are so bad, why will it be bad if rates rise? Asked another way: If you paint yourself into a corner, how do you get out without stepping on the floor? Answer: Simple – you don’t. Zero rate ARE bad and it WILL hurt when they rise, but it doesn’t mean they shouldn’t.

Bill Gross came out with a piece today, and summarized the current conundrum thus:

In the process of reaching and stooping, prices on financial assets have soared and central banks have temporarily averted a debt deflation reminiscent of the Great Depression. Their near-zero-based interest rates and QEs that have lowered carry and risk premiums have stabilized real economies, but not returned them to old normal growth rates. History will likely record that these policies were necessary oxygen generators. But the misunderstood after effects of this chemotherapy may also one day find their way into economic annals or even accepted economic theory. Central banks – including today’s superquant, Kuroda, leading the Bank of Japan – seem to believe that higher and higher asset prices produced necessarily by more and more QE check writing will inevitably stimulate real economic growth via the spillover wealth effect into consumption and real investment. That theory requires challenge if only because it doesn’t seem to be working very well.

He goes on to succinctly summarize the implication:

Why it might not be working is fairly clear at least to your author. Once yields, risk spreads, volatility or liquidity premiums get so low, there is less and less incentive to take risk.

Sure, investors might switch from one overpriced asset to another, but zero bound rates mean companies are hesitant to invest in R&D, savers are hesitant to redeploy now, and entrepreneurs are hesitant to take additional risk on by hiring with lines of credit. I see risk-off everywhere – the business owner not wanting to rent a bigger space to the banker pulling in lines of credit. It’s even bigger than Bill Gross mentions, partly because companies don’t have any control of pricing, consumers aren’t seeing income growth, and on and on and on.

In that light, if the Fed leaves rates low, risk will continue to be mispriced, employment will continue to stagnate, and eventually margin compression will occur and equities will go down. On the other hand, if the Fed increases rates, any financial asset prices dependent on leverage will be forced to come down. So the Fed is in a bind. It can’t leave rates here, because it’s not stimulative, but it can’t raise rates either. It can try to lower them ala Japan, but that didn’t prove to work either. So, it’s just a matter of determining what is the path of least pain. I don’t think anyone has the answer to that one, although many think they know.

Relevant ETFs: TBT, TLT, UUP, GLD