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Sep 18, 2018

What do rising interest rates mean in the current financial climate of “easy money”?

The bottom line is that the days of easy or free money have come to an end.

In 2008 we entered into what is now called the Great Recession. Massive job loss, shrinking economies, collapsing markets and large defaults on bonds were its unfortunate results.

Another result: The Federal Reserve lowered short-term interest rates to roughly zero percent. This was un- heard-of. Most adults had never seen such low rates.

We would have had to think back to the 1960s to grasp what might happen in such an environment. What those rates did fuel for roughly the next decade was a period of “easy” or even “free” money. You could borrow at zero percent and earn 3 percent to 4 percent relatively easily, so what would a good investor do but take the free money?

Indeed, stock markets have doubled and kept going up, and everything has been cheaper to finance than in any other period in our lifetimes: Interest rates on automobile purchases and on longterm financing, including financing to buy homes, have hovered at around 3 percent.

Corporations, moreover, have been able to go to the debt market and borrow massive amounts of money cheaply, and expand with those funds.

At some point during this cycle, the equity markets became addicted to low interest rates and easy money. They continued to move ever higher, assuming that the Ben Bernanke punch bowl would continue to be available. Bernanke never wavered from this policy during his time at the Fed until right before he was ending his tenure, when he announced that the Fed may be stopping the bond-buying program known as quantitative easing. This signaled the incoming Fed chair, Janet Yellen, to tread lightly on the subject, as she knew that any fear of rising interest rates would also spook the market and create big sell-offs. However, when Janet Yellen began (post-2014), the Fed finally made the first rate increase. Markets took this in stride, not moving too much. And that stance has continued through today.

As of this writing, the Fed funds’ short term borrowing rate is roughly 1.75 percent, hardly what we would call a high interest rate, but it is starting to go higher compared with the past decade.

This has caused longer-term interest rates to rise, and unfortunately, that has spooked the market. Truth be told, we are still at very low interest-rate levels and not yet back to a neutral place, which would be roughly 3 percent on cash. But we are headed in that direction.

The impact of higher interest rates in general sounds scary because the bottom line is that interest on every dollar of credit any of us borrows for housing or capital purchases has gone up, and that means less in earnings for any borrower, or at least higher capital expenditures.

The good news is that the Fed would not feel comfortable raising rates unless the economy was doing well, which it is. On the Atlanta Fed’s GDP tracker page, we’re seeing estimates of 4 percent second-quarter GDP growth.

There is also the fact that we are entering the 10th year of the recovery without another recession, which is almost without precedent (120 months is the maximum number of months on record without a recession).

This previous record occurred during the 1990s, ending only when the tech bubble burst in early 2001; In the current expansion, we are close to equaling it. Chances are that within a couple of years, we will have another recession. We expect that interest rates will not go up in a straight line, and most likely we will have at minimum a pause, and at maximum lower interest rates.

So what does this mean? What it translates to is a return to normalcy. We have not seen “normal” in a long time, and frankly it is a relief to see it come back, at least temporarily. The bottom line, however, is that the days of easy or free money have come to an end.

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