The Fed Is Going To Break Something, Somewhere

The Fed Is Going To Break Something, Somewhere
Stéphane Renevier, CFA

over 1 year ago2 mins

The Federal Reserve’s interest rate hikes are supposed to result in an “ordered slowdown” of the US economy, but that’s not actually what tends to happen. In fact, they almost always end up precipitating a crisis. You can see this in the chart above, which shows the various crashes that have happened on the back of rate hikes since 1915.

It’s simple enough to explain the connection. These hikes often come on the back of long periods of falling rates, which encourage companies and individuals to borrow big and spend big. That, by definition, tends to create bubbles – only for those bubbles to burst when the easy money dries up. Some of the biggest crises we’ve had – namely the dotcom crash or the global financial crisis – have followed moments in which investors were empowered to take on more and more debt and bigger and bigger risks.

But here’s the thing: even if rate hikes don’t lead to a crash in the US, they’re bound to cause damage somewhere. That’s because the US dollar usually gets stronger when the Fed raises rates, which increases borrowing costs for the rest of the world. As for who’s most at risk, that would be emerging markets: a stronger dollar makes payments on their government debt – which they often price in US dollars – more expensive, increasing the risk of default and making it more difficult for them to borrow in the future. What’s more, investors are less likely to go looking for returns in riskier emerging markets if they can earn them from a safe asset like the US dollar. That leads them to pull their money out of the economies and can send them sprawling.

That brings us to today, when the Fed is embarking on one of its most aggressive hiking cycles ever after years of rock-bottom interest rates. There are plenty of other unknowns in the market too, like how the economy will respond to higher rates, how resilient the market really is, and how indebted private equity firms and hedge funds are. So hope for the best but prepare for the worst: account for the risk of something, somewhere breaking. Keep your risks low, your positions small, and make sure you’ve got plenty of cash on hand.

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