“It’s not that they can’t see the solution. They can’t see the problem.” – G.K. Chesterton

Chesterton had a way of putting it just right. The solution may be simple. The difficulty is in clearly seeing the problem.

Over the past few weeks many of our clients have been asking about interest rates and where they might be headed. The consensus seems to be that they are going up. The experts in the media say so. The Federal Reserve says so. And market rates have moved up considerably in the last few weeks.

So are interest rates going up? Yes…and no.

“Interest Rates Are Going Up”

In the span of less than two months since the election of Donald Trump, the S&P 500 is up more 6%, Consumer Sentiment has risen to a 13-year high, and investor “bullishness” about the market is once again on the rise. With all this good news, the chorus of bulls is drowning out any semblance of reality. They are – excuse the pun – milking this Trump bump for all its worth.

The irony (one of many) is that those who were claiming the sky would fall in the aftermath of a Trump win are now proclaiming the opposite. It’s the classic “change-the-facts-to-fit-the-story” sort of thing. A Trump presidency – apparently only on this side of November 8th 2016 – will usher in massive regulatory reform, a stock market boom, and an increase in economic growth. All this, we are told, will lead to higher interest rates.

There’s only one problem: it isn’t true. Fundamentals suggest the economy is unlikely to increase its growth rate. But even if it did, it wouldn’t be the factor that leads to rising interest rates. We can lay this confusion at the feet of the vague correlation many see between GDP growth and interest rates. Generally speaking, as GDP growth rises, interest rates go up. And vice versa. But, as anyone familiar with basic logic knows: correlation does not equal causation.

“So Interest Rates Are Going Down?”

To dissect the issue sufficiently, and define the terms necessary to do so is beyond the scope of this blog. But fundamentally speaking, a stronger economy does NOT lead to higher interest rates. Quite the opposite, actually. If Trump’s policies were truly going to “Make America Great Again” then all things being equal, interest rates should decline. Why? Because a stronger economy is driven by increased savings (i.e. investment), and more savings means more supply of capital. As the supply of capital increases the price falls. And that’s what interest rates are: the price of capital.

Besides mistakenly believing that correlation equals causation, this superficial analysis also ignores the influence of the elephant in the room: the Federal Reserve System. This entity artificially and destructively manipulates interest rates as a way of both controlling economic growth and destroying the value of the dollar. A golfer must account for both the bunkers ahead as well as the strong east wind. Likewise, any economic analysis worth its weight in gold can’t just focus on the theoretical or practical aspects of economic theory. It must also factor in the artificial influences of the Federal Reserve. Currently, the Feds have kept interest rates artificially low. More on this in a moment.

Seeing The Problem Clearly

So here’s the problem: interest rates need to go up. They need to go up because they have been artificially suppressed for too long by the Federal Reserve. BUT, this isn’t the same as saying that they will go up. They have been suppressed artificially, which has led to bad investment – a lot of it. At some point, because all this bad investment has made the economy weaker – not stronger – interest rates will go up significantly. We could be headed for a 1970s redux.

But, the conditions for such a rise in interest rates are not yet in place, nor are there any signs that such conditions are imminent. So what does that mean? Simply put: interest rates are not likely to go up now. Not yet, anyway.

And let us be clear about the other elephant in the room: a recession is coming. Whatever good things Trump may do in regards to regulatory or tax reform, he cannot prevent the inevitable. The recession may not be imminent, but the odds of one hitting during his first term are very high. And underlying economic fundamentals continue to suggest the US economy is a fly in search of a windshield.

At this point you may be utterly confused. Trust me, you are not alone. A strong economy should lead to lower interest rates. Likewise, a weak economy should lead to higher interest rates. But what we have right now is a weak economy with low interest rates. This incoherent situation has been created and perpetuated by the Federal Reserve system. This is the problem, and it’s incredible how few people see it.

So…What Comes Next?

At some point these central planners (i.e. quasi-socialist schemers) will lose control – they always do. But until then, their influence will continue to be the driving force behind interest rate movements. And as we enter the next recession, the Keynesian Feds can be counted on to do one thing: put downward pressure on interest rates. That is, for all this hoopla in the media, the odds are interest rates will be lower three to five years from now. It’s that simple. The difficulty is clearly seeing the problem.

If you want to learn more about our economic outlook, our financial services, or our disciplined investment process, give us a call! We look forward to hearing from you.

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