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Financial Storm May Depend on US Federal Reserve
Continued Short-Term Rate Hikes Might Trigger Recession
By Jeff Hussey, Portfolio Manager
Russell Investment Group
October 11, 2005
Taken from the US version for public and pro-sites
Investment managers are becoming increasingly concerned about the steady rise in short-term interest rates engineered by the US Federal Reserve.
They are afraid that the Fed's action might lead to short-term rates overtaking long-term rates, a situation that could possibly create recessionary conditions in the US Canadian investors should also pay attention to the US Federal Reserve's interest rate policy, since any downturns in the influential US economy could negatively impact the Canadian market.
As the Fed has boosted the federal funds rate 11 times over more than a year, short-term rates have been heading ever closer toward long-term rates. But long-term rates have stubbornly refused to climb, staying at more or less the same level.
Two years ago — on Sept. 26, 2003 — 10-year Treasury Bills were priced at 4.04% and 1-year Treasury Bills at 1.21%. On Sept. 26, 2005, 10-year Treasuries were 4.30% and 1-year Treasuries 3.95%¹.
Two more 0.25 percentage-point increases by the Fed and short-term rates might overtake their long-term counterparts—if long-term rates stay more or less where they are now. And that could play havoc with the economy.
Recession Direction?
The investment managers I talk to daily in managing our multi-manager investment products also are concerned that the steady rise in rates on which the Fed has embarked might, in itself, spark recession through continuing too long.
The Fed is raising rates because it fears inflation is of greater concern than growth and that higher rates will squelch inflation while maintaining reasonable economic growth.
If the Fed proves to have been right, they will have engineered a soft landing, averted recession and proved the naysayers wrong.
Yet many investment managers believe inflation is tame and no reason exists to raise rates further. These managers see the risk as the Fed misreading the strength of the economy and that further hikes will create a recession.
Mother Nature's Influence
Throw two damaging hurricanes into this mix and the picture becomes even more clouded. The resulting higher energy prices may sufficiently dampen the economy to make it unnecessary for the Fed to raise rates much further.
But the Fed has made it clear that it considers the threat of inflation a bigger concern than the threat of a slowdown in the economy.
History also is not on the Fed's side. Almost every time in the past 20 years the Fed has consistently raised rates—as it is doing now—the result has been a recession. Climbing rates combined with negative economic growth, as measured by GDP, to cause recessions in 1993, 1998 and 2000.
As a result, investors who generally look down the road six months to a year may be undecided about which way to place their bets due to lack of clarity whether the Fed will be proven right or wrong and whether we will be faced with a recession or a soft landing.
Their uncertainty is reflected in a market that has essentially been going nowhere recently.
¹Data obtained from the U.S. Department of the Treasury at www.treas.gov.
Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
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