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Federal Reserve to Please No One

September 14, 2015 / Jonathan Holtaway and Jacques Rebibo

In the Washington area, we live in a fairy land.  The credit crisis spawned a massive increase in government expenditure.  A good portion of these expenditures become “revenues” coursing through the Washington suburbs. Our housing market is ebullient because a couple of staffers at the FDIC, or choose your agency, making the average salary of $125k can easily upgrade their 50 year old Arlington rancher and replace it with a four thousand square foot modern construct. Money is cheap for anyone that fits the box for accessing credit.

Like Washingtonians, rich people have had a good run.  Income producing assets have vaulted higher thanks to sustained low interest rates.  Even trophy assets like Hampton houses and art have boomed.  The stock market set new highs this year at 60% above the level in 2007 just before the credit crisis began.

The one group that has had a pretty raw deal is the middle class.  Housing, jobs and modest retirement savings are the primary source of middle class wealth and all were heavily dented in the credit crisis.  The recovery in housing and jobs has been slow with the exception of fairy lands like Washington and San Francisco.

As we watch the stock market wobble and consider the first interest rate hike in eight years, the conventional wisdom is that the party is over.  Asset prices must fall.  A six year bull market tracing to the 2009 panic low is long in tooth by historical standards.  The negative catalyst is an emerging market crisis tied to a slow-down in China.  The canary in the coal mine is commodity prices.  Oil, coffee, wheat, metals – you name it – all are well off their highs.  Commodity focused exporters like Brazil look to be in for hard times.

Many market observers want the Federal Reserve to hold off increasing interest rates. They believe rising rates will accelerate the emerging markets crisis, dooming world growth and dragging down the US economy.  The argument is that even though 25 basis points is a miniscule increase in debt costs, higher rates will strengthen the dollar so much that dollar denominated debt will excessively burden emerging markets just like the 1997-98 Asian crisis.  We saw similar arguments made in 2013 around the market jitters caused by the “Taper Tantrum”, which was when the Federal Reserve first mentioned it would reduce the rate of quantitative easing.

Given the fear abroad and the lack of any near term inflation risk, why is the Federal Reserve “keeping its options open” for a September rate hike?  Perhaps it’s because monetary policy is a blunt tool that requires many months of lead time to have its effect.  Or maybe the Federal Reserve is cognizant that low interest rates creates winners and losers.  High finance likes a well-supplied punch bowl to drive levered strategies, but it has been at the expense of retired savers and pension funds being denied fair returns on their capital.  Not raising rates because it disrupts aggressive, cross currency leveraged transactions creates moral hazard and a bigger problem down the road.

Since the Fed’s tapering began in the fall of 2013, the US economy has continued to strengthen.  Raising short term rates in 2015 is a logical extension of reducing the historically long monetary accommodation.  Understanding the Fed’s policy choice means taking a stand on the cause and likely impacts of the troubles in emerging markets.

Although China is in the news today, the first significant part of the emerging market crisis began when the price of oil crashed in the fall of 2014.  The fall-off is generally attributed to supply side developments such as the rapid development of shale oil in the United States.  In response to rising world supply, Saudi Arabia abandoned production restraint to protect its market share.  As described in Daniel Yergin’s bestseller, The Prize, the result has been a good sweating.  Low prices are driving high cost producers into bankruptcy, chasing away new supply entrants and enticing consumers to use more energy.

This is classic supply side competition benefiting consumers and it promotes growth!  Producers and their financiers are in pain, but this is dwarfed by the spending power delivered to consumers.  Instead of petro dollars, you get middle class spending amplified inside the US economy.

It is a secular event with little to do with monetary policy and everything to do with the oil market.  Nevertheless the financial strains on producer countries is real.  The idea, though, that US monetary policy is a decisive factor for oil producing countries just doesn’t make sense.

China’s decline is different.  China attracted huge investment flows and used the money to build infrastructure, housing and productive capacity.  This process drove commodity demand sufficient to buoy supplier prices the world over.  Bubble conditions such as Australian truck drivers earning $200k/year were one result.  As the China investment tide reversed, commodity prices slipped.

In the United States, the Chinese slow down means consumers get a double benefit of lower commodity prices and lower cost of goods from China.  The same positive forces will play out in the other major first world consumer market, Europe.  Given the positives, why is the US stock market suddenly so volatile and scary?  Why is the IMF and World Bank so desperate to slow the Federal Reserve from raising rates?

The short answer is worry about a “gorilla”, which is the meltdown of a financial company or hedge fund large enough to move markets.  Petrobras, the Brazilian national oil company, is an example.  It has borrowed billions in debt from Western financiers to develop offshore oil fields too expensive to compete unless oil prices recover.  If a gorilla emerges, everyone has to stop and worry if key financial counterparties might be exposed.  It is a process that gums up markets and causes liquidity driven price declines.

Whatever the international landmines, truly US based companies are enjoying an environment that looks very good.  Consumer goods, consumer services and housing should remain healthy and growing.  US focused banks like the entire community bank sector will do well benefitting from loan growth from their customers and higher rates from the Federal Reserve.

In the short run the money centers and large regionals will suffer from the “cloud” of a possible financial gorilla, but this will dissipate quickly unless a real one emerges.  Large US banks are dollar earners, dividend payers and benefit from rising US rates making them compelling in a world shorn of its dividend paying oils.

The 2008-09 financial crisis was a housing crisis that devastated the American middle class.  This critical group of consumers has begun to heal and now has some financial tailwinds from energy, a stronger dollar, lower import prices and more plentiful jobs.  History suggests Americans take their good fortune and spend!  Economically this is a more significant source of gains than the pains felt in the oil patch or even China.  A robust US economy will help both find their footing.

Jonathan Holtaway

Jonathan Holtaway

Jon Holtaway is an expert in the banking sector and has been quoted in national publications such as The Wall Street Journal, The Financial Times and The Washington Post. As a hedge fund manager and former investment banker, he has dedicated his career to investment analysis and building relationships in the banking sector. After spending twelve years with a premier regional investment house, Jon has co-founded two companies and has extensive experience working with wealth management and residential mortgage companies. Jon serves on the board of a publicly-listed community bank holding company, Hawthorn Bancshares ("HWBK"). In his free time, he is a passionate reader and writer. He authored “The Growth Penalty: Unfinished Business, Banking and the American Recovery” in 2013.

Jacques Rebibo

Jacques Rebibo

Mr. Rebibo has been a community bank investor for over 30 years. He entered the banking industry in 1985 when he invested in and joined the board of a de novo bank, Fairfax Bank & Trust. In 1999, Mr. Rebibo was an organizing director and subsequently became Chairman for nine years of Access National Bank, which grew to $3 billion assets before selling in 2018. In 2009, Mr. Rebibo co-founded and was Chairman of 1st Portfolio Holding Corporation, a residential mortgage and wealth management company. 1st Portfolio was sold to WashingtonFirst Bankshares, “WFBI” in 2015.