Not in a Million Years

Storylines serve a valuable purpose.  They round out the incongruences and give meaning to things in a way people can quickly comprehend.  This is especially true when it comes to the economy.

The popular narrative of the day is that the U.S. economy is moderately improving while the world’s other major economies – Japan, China, and Europe – are bittering over like a cold cup of coffee.  But is this positively fact or is it mere fiction?  Have the raconteurs missed the plot?

Stock market investors can’t make up their mind.  They want to believe the story.  But they have their doubts.  One day the DOW runs up 200 points.  The next day it gives it all back…and then some.

Anxiety over what the Fed will do with the federal funds rate is of particular interest these days.  Will they raise rates?  Will they hold them at zero?  Perhaps later this week we’ll find out more.

The notion that the U.S. economy is strengthening is the storyline that will prompt the Fed to raise rates sooner than later.  Of course, higher rates make borrowing money to speculate on stocks more costly.  Getting out ahead of a Fed announcement, and before the stampede for the exits, has some investors on edge.

Signs of Financial and Geopolitical Distress

The dollar is also anticipating a Fed rate hike.  In fact, according to Bank of America, the dollar is on target for its strongest quarterly strengthening since 1992.  The expectation of rising rates and a strengthening dollar has become self-reinforcing.

People are rapidly exchanging other currencies into dollars in anticipation of a rate increase.  The higher demand for dollars increases its value.  The higher value encourages more people to buy dollars, which further drives up the currency’s value.  Nonetheless, for dollar holders and holders of other currencies alike, the rapid valuation of the dollar isn’t without its own risks…

“In the past, significant dollar gains against other currencies have pretty much happened only during periods of extreme financial or geopolitical distress,” reports Reuters.

“The last four large dollar shocks in the past 45 years have been symptoms of huge financial events: the collapse of Lehman, Britain’s panicky ejection from the European Exchange Rate  Mechanism (ERM) in 1992, the first Gulf War, and Paul Volcker’s shock rate hikes in the early 1980s.

“Today’s surge is already considerably larger than the one that surrounded Lehman’s collapse, although the economic conditions are very different.”

Not in a Million Years

The federal funds rate has been pressed down to practically zero for over six years.  The global economy and financial markets have become dependent on artificially low rates.  Any change to this model will expose weaknesses.

Financial decisions – lending and borrowing and the ventures they support – the world over have been predicated on ultra-low rates.  When rates start to go up, certain ventures will no longer be profitable.  Economic dislocations will come to the surface.

At this point no one quite knows where they will show up.  Like natural gas pressurized in an underground cavern it will follow the path of least resistance.  A crack or fissure will provide a conduit to the surface…where it will explode.

Maybe a hedge fund will blow up.  Or another big Wall Street bank will be vaporized.  There could be a mass currency devaluation.  Perhaps employees of a Fortune 500 company will show up to work one Monday morning and find the doors locked; they’ll get 20 minutes to box up their stuff and split.

Conceivable, all these things could happen all at once.  These are the consequences of monkeying around with the price of money.  The distortions the cheap credit haphazardly supports have stacked up like a wobbly Jenga tower.

At the same time, the problems that prompted the initial credit issuances were papered over.  Yet they never went away.  They’ve magnified and expanded and will soon blow up again.

No doubt, the Fed will do anything and everything when things go up in smoke.  They’ll stand any semblance of prudent financial management on its head.  But can they pump the monetary gas into the system at a rate fast enough to replace the outflow of bad debts and defaults?

Not in a million years.

Sincerely,

MN Gordon
for Economic Prism

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