The Odds of a Rate Hike Just Went Up

March 1 2017

The odds of the Federal Reserve increasing interest rates in March have just spiked. Whether the Fed decides to raise interest rates either at the next FOMC-meeting or afterwards, market interest rates are experiencing a rapid increase. The Fed suddenly became the naked emperor. While market rates are on the rise, the members of the Fed’s interest rate committee must pretend that they now, out of a sudden, do have valid reasons to increase the Fed rate: higher inflation, lower unemployment, etc. But the true motive of a rate hike is much more sobering: the Fed’s decision makers do not want to hike rates, but are forced by rapidly increasing market rates.

Market Interest Rates Are on the Rise

What do I mean with the market rate? The 3-month LIBOR dollar rate has jumped to 1.05% (from 0.25%), while the 12 month USD LIBOR has risen to even 1.75%.

What is the LIBOR interest rate? LIBOR stands for London Interbank Offered Rate and is a benchmark for the market rate that banks charge each other for short-term loans. This benchmark is the most used in the world, especially in all types of credit agreements (in which the nominal interest rate is determined as LIBOR + a risk premium).

Let us go through a chronological account of recent interest rate movements:

  • The Fed, since 2008, no longer targets a specific interest rate, but a range
  • Then, the Fed lowered the interest rate to 0.25% - 0.50%
  • The LIBOR rate dropped even to 0.22%, slightly below the Fed’s target range
  • In September 2015, the LIBOR rate was rising for some time until it reached a modest level of 0.35%, which was within the Fed’s target range at the time. In December 2015, the short-term LIBOR rate went through the 0.50%, the Fed’s interest rate ceiling on bank reserves.
  • The chicken or the egg? Does the LIBOR rate begin to rise because the market expects a higher Fed funds rate or is the Fed being forced to follow the market interest rate? Whatever the answer may be, at the end of December 2015, the Fed decides to hike rates to 0.50% - 0.75%. The LIBOR rate, again, is within the Fed’s target range.
  • It is August 2016: something odd occurs. For the first time, the LIBOR rate takes off and starts to rally. As a result, the LIBOR rate breaks through the Fed’s rate ceiling. The LIBOR rate rallies to a level of 0.99% in December, far above the Fed’s funds target rate ceiling.
  • At the end of December, the Fed decides to hike the Fed funds rate to 0.75% - 1%
  • The LIBOR rate continues to increase to 1.05% and exceeds again the ceiling of the Fed’s target range.

In other words, the Fed follows the market, not the market the Fed. And the LIBOR rate starts to pick up pace.

Observe the above account of events in the following graph:

Source: St Louis Fed

Why are market interest rates on the rise? What is happening? The rise in market interest rates has everything to do with increasing inflation.

There exists an important relationship between inflation and long-term interest rates. And that means that, as soon as inflation picks up, long-term interest rates will begin to increase.

When prices rise (that is, inflation), the demand for credit increases and interest rates jump.

The only thing that the Fed can do is to follow the LIBOR rate. And that means that an interest rate hike will come rather sooner than later. It is completely imaginable that the LIBOR rate continues to increase, and as a result the Fed will be forced to increase the interest rate, maybe even several times this year. The next FOMC meeting on March 16 will possibly be accompanied by an interest rate increase, especially if the LIBOR rate continues its rally in the coming two weeks.

A higher interest rate is normally bad for gold (because gold is not an earning asset: a higher interest rate means higher opportunity costs), but this time around I dare to say that things will be different: a higher interest rate implies a recession and a stock market crash. And the reaction of the Fed will be the same as in the past: lower interest rates. In other words, the big paradox is that a higher interest rate will lead to lower returns on stock markets and, indirectly, to lower interest rates.

Keep a close tab on the LIBOR rate.

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