As you may have already heard, the Federal Reserve (the “Fed”) raised interest rates for the first time in almost ten years.  What this means for the economy over the next few weeks and months is anyone’s guess.  This is all new for the Fed and the financial markets and what happens next is the other side of the quantitative easing programs that ended in the recent past.  What is unusual about the Fed’s move relative to past interest rate hikes is that the other hikes came at a time when the economy was starting to overheat (rising inflation, strong economic activity and rising production).  This move has come at a time when economic activity appears to be slowing down.  We certainly understand the need to get back to “normal” interest rates, but, in our opinion, doing so should have started more than a year ago when the economy was stronger.

Why shouldn’t the Fed raise interest rates now?  Primarily because economic conditions have worsened over the past few months.  Economic activity around the world has slowed down as most every major country is seeing a drop in export activity.  That is why China and Europe recently lowered interest rates.  Commodity prices have also weakened recently.  This has a deflationary affect on the economy, not inflationary.

Economic activity seems to be slowing down in the US as well.  The Purchasing Manager Index (“PMI”) has fallen below 50 for the first time since the end of 2012 (please note the gray areas on the chart accessed by the link above indicate recessions).  Just before the PMI fell below 50 in 2012, the Fed implemented the third phase of its quantitative easing program.  This program was a much more accommodative program to the economy and has the complete opposite effect on an economy than what the recent interest rate increase will.

Swift Transportation, the largest truckload carrier in the United States, recently cancelled orders for 450 new tractors.  If business outlook was strong for Swift, it’s likely they would not have cancelled that order.  Additionally, the high yield bond market has shown signs of stress over the past few months.  As a result, the Third Avenue Focused Credit Fund decided to freeze its assets, which prevents its investors from getting their money out of the fund.  People forget that the Fed started lowering interest rates at the end of 2007 because of stress in the mortgage market.  The signals we see today in the economy point to an easing of interest rates, not an increase in them.

What does this mean for portfolios?

So, what happens from here?  If high yield bonds and commodities continue to face pricing pressure to the downside, expect no further rate increases – in fact, rates may turn negative like they have in Europe.  Same thing if the economy continues to slow down.  Quantitative easing was a grand experiment – we will now see what happens on the other side.  Volatility, for sure, is here to stay for the foreseeable future.