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The Road Map to Higher Interest Rates: Seven Signs of the End of Free Money
by Louis Basenese, Small Cap and Special Situations Expert
Thursday, February 4, 2010: Issue #1190
Looking for an exact date as to when Ben Bernanke and his fellow Fed bankers will raise interest rates?
Sorry… I don’t have that for you (I loaned my crystal ball to Miss Cleo for her new infomercial.)
But what I can do is give you a “Road Map to Higher Interest Rates,” which spells out the specific events that should precede the most anticipated hike in history. Follow it and you should be perfectly positioned to profit when the time comes.
(Remember, a few months ago, I introduced SSFRs, an investment that you’ll want to own when interest rates rise.)
So without further ado…
Seven Signs of the End of Free Money
It’s important to remember that the Fed adjusts rates based on inflation expectations. And right now, there’s too much slack in the economy for inflation to be an immediate concern.
In fact, the United States hasn’t seen this much slack – the amount of actual GDP production versus the potential production if all economic resources were being employed – in over 25 years.
And that means the Fed won’t consider a rate hike until these three data points improve:
1. Unemployment: Needless to say, it’s uncomfortably high – and is a key contributor to economic slack at the moment. We’ll need to see a definitive return to growth here. (Remember, the economy added 4,000 jobs in November, only to lose 85,000 in December. And the latest ADP report suggests the losses carried over into January.) Once unemployment peaks, the Fed usually waits at least a year before raising rates.
2. Factory Utilization: If our factories aren’t running at full-tilt, there’s no way the economy is either. That’s the case now, with factory utilization near a record low of around 72%. In the last two decades, the Fed has waited to raise interest rates until factory utilization rebounded to around 80%, so we need to see significant improvement here.
3. Wages: Economic slack also shows up in wage growth. After all, when companies are ferociously cutting costs and employees are worried about simply having a job, raises are virtually non-existent. Given the severity of this downturn, it’s no surprise that wages fell at their fastest pace in 25 years. We need to see a pronounced rebound before the extra money in consumers’ hands prompts the Fed to increase its inflation expectations and, in turn, raise rates.
Watch What the Fed Does, Not What it Says
Beyond the economic data, we need to focus on the Fed’s actions. Every move is intentional, but the bankers don’t always call attention to them in their speeches. I’m convinced that the Fed must do the following before hiking rates:
4. End the Easing: The Fed introduced nearly half a dozen “special liquidity facilities” to navigate the financial crisis. Some included ridiculously cumbersome names like the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity-Facility.
So it only makes sense to unwind these facilities before tightening monetary policy. Four of them expired as planned on February 1. And the program aimed at purchasing $1.45 trillion in mortgage-backed securities will end in two phases – on March 31 and June 30. However, the Fed can extend these programs if necessary, so if it does, that pushes out the timeline for a rate hike.
5. Sop Up Extra Cash (temporarily): Before the Fed hikes rates, it will look to drain extra liquidity out of the system. So look for the bankers to use newly introduced term deposits and reverse repurchase agreements.
The first acts like a traditional certificate of deposit and encourages banks to keep their reserves on deposit rather than lending them out, which would accelerate inflation. The second involves the Fed selling securities from its portfolio with an agreement to buy them back later.
Keep in mind that these are temporary fixes, as the cash is ultimately returned. But the Fed will need to ramp up these special tools before hiking rates.
6. Sop Up Extra Cash (permanently): The amount of excess reserves in the banking system will also require the Fed to remove cash permanently. Expect the Fed to sell some of its long-term securities outright to accomplish this.
7. The Fed Changes Its Policy Statement: Each word in the Fed’s statement is chosen wisely. And at least a month in advance of raising rates, the Fed will need to strike one or two key phrases that have been mainstays throughout the crisis – “exceptionally low” and “extended period.”
In the end, my road map isn’t necessarily sequential. Nor do I think the Fed needs to follow it to the letter before raising rates. Economic conditions are fluid and therefore could prompt a swifter move.
That said, the more items you can tick off, the closer we’ll be to the most heavily anticipated rate hike in history. So start keeping track now.
Good investing,
Louis Basenese
Editor’s Note: When it comes to investing – and profiting – success comes not only from the quality of the information that you gather, but when you get it. Lou’s article above serves as an “early warning system” for the Fed’s monetary policy moves… but he’s not done there.
In the February issue of The White Cap Report, released just yesterday, he’s given advance notice of another profitable area – technology. Specifically, he’s tipped investors off to three of the most promising technologies set to make headlines this year.
And if you want to grab the maximum profits, you’ll need to know about them before they hit the mainstream headlines. Find out how you can by signing up for a risk-free trial to The White Cap Report.
- The Fed Raises the Discount Rate: What It Means For You
- The Fed Fund Rate Announcement & Interest Rate Decision
- My Confrontation With Ben Bernanke: The Question He Refused to Answer
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4 Responses to “The Road Map to Higher Interest Rates: Seven Signs of the End of Free Money”
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In addition to being the foremast expert on small-cap stocks, Louis is also well versed in special situations including IPOs, mergers and acquisitions, spinoffs and contrarian investments. His commentary has been featured in several media outlets, including MarketWatch. And he's also a top-rated speaker at financial conferences throughout the country. 
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February 4th, 2010 at 1:17 pm
Lou,
Here’s #8:
When mortgage resets and the subsequent foreclosure wave have been absorbed by the system. Any raise prior to this means instant equities crash.
I don’t think you’ll see higher rates until mid 2012 at the earliest.
Reply
February 4th, 2010 at 4:27 pm
Good article! There’s a lot of drivel out there about the “impending inflation”. You are one of the rare few who truly understand the causes of and the Fed’s remedies for inflation.
Reply
February 5th, 2010 at 7:14 am
Lou, I agree with Bill – Though I can’t comment specifically on the equities market, until we can stabilize and absorb the inventory out there, I don’t see how the system can handle higher rates and recover. Great post, thank you for the excellent, common sense presentation.
Reply
February 7th, 2010 at 1:43 pm
good read, thanks. Afactor that I’ve not seen mentioned when the reclining wage rates are mentioned is the fact that many companies cut the older more mature workers to shed their higher salaries. They jeep, sometimes re-hire workers at the lowest salary-benefit levels possible to squeeze down payroll-benefits expenses. Also frees up more money for the CEO/upper echelon bonus fund.
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