Investors consume a lot of energy guessing the Fed's next move

A colossal waste of time

You can’t watch Bloomberg, CNBC or BNN for half an hour without one talking head or another pontificating over whether the Fed will begin to cut interest rates in the first quarter of 2024, the second quarter, later in the year or not at all. The sell-side machinery salivates at the prospect of lower rates and the chance they will fuel economic expansion and higher stock prices and a surge in bond prices. Who can blame them?

Me.

Higher prices for stocks and bonds compel lower returns after the short term rush that drives prices higher. Once there is an equilibrium a less attractive environment obtains. People who buy bonds once the lower rates they hope for are established and hopefully stable, they will get less interest on their holdings. People who buy stocks will get lower streams of dividends as a percentage of the money they have invested, offset somewhat by the growth the lower rates is hoped to engender. If the rate cutting period lasts a year or two, fund managers and advisors will break out the champagne, charge their clients higher fees for their “performance”, and buy new Range Rovers or Teslas. Their clients can read monthly statements telling them how much they have “gained” but what they will actually receive will be interest and dividends since to benefit from high security prices they have to sell, pay fees and commissions and for many pay more in income tax, and from that point receive less income as a percentage of their at-risk capital.

Current interest rates on treasuries are four to five percent and inflation is running about 3%. With taxes at 40% for most people, after tax returns from bonds are near zero when adjusted for inflation. With the Fed realizing its goal of 2% inflation (why 2%, real price stability is zero inflation), and rates lower by 100 to 200 basis points, bond investors will earn a negative after tax inflation adjusted rate of return. The bond market is much larger than the stock market so the impact of lower rates becoming persistent and pervasive is lower income for bond investors.

At present, stock investors in the American markets (represented by the S&P index) pay about 16 times earnings for shares and receive dividends that comprise on average 1.5% of their investment. A return to growth in the economy (3 to 4% is the norm) might see a multiple of 18 times if inflation is indeed beaten down to 2%. After tax corporate income and dividends will grow more or less in tandem with economic growth so the equilibrium post rates cuts will see a stock with a share price of $16 today trade at $18 per share at the higher multiple reducing the dividend yield to 1.3% but growing at 3 to 4%. With inflation at a steady 2% (the Fed’s target) investors after tax inflation adjusted real return will settle at 2.3% to 3.3%. At least it is a positive number, but advisors and fund managers will eat up 100 to 200 basis points of that return for sharing their “expertise” and ordinary blokes whose money is actually at risk will get about the same rate of real return in the lower rate environment as they enjoyed in the higher rate environment.

So who benefits from the whole charade other than sell-side managers and brokers? The answer is the U.S. treasury benefits by having the ability to kick off the next toxic cycle by issuing more debt at lower rates and repaying existing debt with inflated dollars.

The goal to quell inflation is the right one, but the overt market manipulation of interest rates is the wrong approach. A free market approach that encourages greater supply of energy (oil & gas), expanded supplyof homes (residential construction), and increased supply of metals and forestry products will quell inflation, and will manifest itself in an environment of lower taxation, less government borrowing, and less intervention in markets. In the 123 years of American history before the Fed was created in 1913, inflation averaged 0.4%. The creation of the Fed fueled higher inflation, not lower inflation, and the incessant market manipulation undoubtedly interfered with the robust economic growth that I say would have endured without that intervention. Big government, economic intervention, higher taxes and higher borrowing by governments did not serve citizens well despite its popular appeal to socialists. It will persist as long as electorates keep believing governments can create something from nothing and continue to elect so-called “progressive” governments.