What Happens If The Fed Raises Rates?

Janet-YellenJeff D. Opdyke:  Tomorrow (Thursday) might well be the single-most anticipated Federal Reserve announcement in nearly a decade. Will it or won’t it raise interest rates?

It’s almost like the Catholic world awaiting white or black smoke from the Vatican chimney to announce that a new pope has — or has not yet — been elected.

The only practical difference is that one decision speaks to heaven … and the other is just a reminder that we’re all on a handcart to hell, no matter the decision made.

Do not be surprised if tomorrow, just after the Fed’s 2 p.m. announcement, Wall Street rallies — possibly significantly.

I see this rally happening for one of two reasons:

  1. The Fed does not raise rates. It will say in its announcement that while the U.S. economy is looking healthier and the jobs market is progressing nicely (a lie, as I showed in a previous dispatch), Fed governors are nevertheless concerned about instability globally, a not-so-oblique reference to China.
  2. The Fed does raise rates … but it raises by less than 0.25%. It will say in its announcement that the U.S. economy warrants a small move higher, but that the global economy is still fragile and the Fed doesn’t want to upset the apple cart by being too aggressive with its rate-hike cycle. Moreover (and this is the part that engenders a stock-market rally) the Fed will effectively say “That’s all folks!” The governors will have given the world what the Fed promised — a rate hike by the end of the year — but it will send a strongly worded message that no further hikes are in the offing for a long time.

Which of these two is most likely? And what happens if the Fed raises rates?

It’s a crapshoot, since divining the mood of the Fed is black magic at best.

Still, I lean toward Option No. 1.

The Fed, though focused on what’s best for the U.S. economy, cannot disregard the impacts a decision to raise rates will have on the global economy … and a rate hike would have meaningful impacts.

So what happens if the Fed raises rates?

First and foremost, it pushes the U.S. dollar higher. Interest rates in America would widen between much of the developed world (or narrow relative to Canada, the U.K., Australia and New Zealand). That’s bullish for the dollar because it means investors can sell local currencies such as the Swiss franc, euro, Danish krone and others and capture as much as 1%. That will bring money into the dollar, which means increasing demand for greenbacks, which raises the dollar’s value.

The stronger dollar, in turn, slams emerging-market nations that have taken on oodles of dollar debts in the past year. They will struggle to 1) repay higher borrowing costs with 2) local currency that no longer buys as many dollars as it once did.

That’s a prescription for a currency crisis, and the Fed doesn’t want to be the catalyst that tips the world into a new catastrophe.

A rate hike would hurt here at home, as well. U.S. multinationals are already struggling under a stronger dollar. Profit margins for companies comprising the S&P, where nearly half the earnings are derived overseas, are under pressure now. A stronger dollar only exacerbates the pain.

Does the Fed Call or Fold?

Such consequences are what happens if the Fed raises rates. Of course, low rates are already a substantial drag on the economy. Keeping them at such nominal levels creates its own set of risks.

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