Interest rates, monetary compression

History appears to be repeating. Refresh your memory of the past 20 years of short-term interest rate changes here. Just note the late 70’s and early 80’s was a very special time in financial history and should be disregarded for historical “regression to the mean” purposes, similar to how when looking at equity charts one should mentally blank out the 2008-2009 time period as economic-crisis induced.

The last time interest rates were held at a “very low” level was back after the dot-com bubble crashed. The US Federal Reserve dropped interest rates from 6.5% to 1%, which took three years to execute (it took about a year to go from 6.5% to 2%).

Over a period of 2 years, the Federal Reserve from 2004 to 2006 raised interest rates from 1% to 5.25%. Then during the pits of the economic crisis, it took the Fed about a year to drop rates to nearly nothing, where rates remained for seven years until the end of 2015.

Now interest rates are creeping up again, although at about half the pace of the prior interest rate increase from 2004-2006. What’s interesting is that while textbook theory suggests that interest rate increases are not good for equity pricing, the opposite appears to be the case.

However, there is always a lag effect between monetary actions and the actual economic consequences of such actions. I would claim that we’ll really start to see the consequences of monetary tightening around now. Financial deals that seemed better at 0.25% financing do not seem good so good at 1.9%, and at 2.5% will seem even worse.

The real issue is the long-term treasury bond rate, which is currently 3.02%. In theory, if everything in the USA was fine and dandy, that rate should be higher.

Also, the initial signs of US monetary policy tightening is not seen in the USA itself, but rather the foreign markets. This in itself is worthy of a separate discussion, but what we are seeing today in Turkey and other external countries that are facing economic difficulties is not solely due to trade war and tariff talks, but rather that the US dollar is becoming more expensive.

All I can say (and this has become so much of a cliche) is that caution is warranted. Investment capital is best applied at reasonable valuations to entities that clearly have cash flow generation capabilities and ones that do not have complete reliance on credit markets (or conversely ones that will be able to acceptably tap the credit markets to roll-over their debt). This is doubly true if the company in question generates its profit from foreign currency, but borrows in US denominations.

The conventional wisdom says to not time the market, but I deeply suspect that over the next 12 months that we’ll see lower prices ahead.