Lurking behind Wall Street’s six-year-old bull market is Federal Reserve Board Chairwoman Janet Yellen warning of interest rate hikes in this year’s already sideways market. Instead to moving rates up based on solid corporate earnings and GDP growth, Wall Street’s been in a pattern since Jan 1 of quick run-up and sell-offs, leaving the Dow Jones Industrials closing at 17,849, well off its May 18 record high of 18,288. While profit-taking is expected in most bull markets, today’s anxiety about what the Fed’s Open Market Committee will do has put a dark cloud over U.S. markets. Ending the third round stimulus bond-buying programs known as “quantitative easing” or QE3 Oct. 29, 2014, no one knew the market would rocket up almost 2,000 points. Wall Street’s spectacular rise since it hit rock bottom March 9, 2009 at 6,547 kept the U.S. economy from almost certain recession.
Adding some 10 million private sector jobs since April 2010, Yellen’s waited patiently to raise the Federal Funds Rate from zero-to-0.25%. Ending QE3 Oct. 29, 2014 and now considering interest rate hikes comes with uncertainty, not knowing how the GDP would respond. Given the U.S. economy’s poor GDP growth in 2015, it’s made raising interest rates more difficult. With the GDP for Q1 at 0.25% and Q2 at under one percent, Yellen faces tough choices before the Fed’s Open Market Committee meets in August. Yellen promised that once the unemployment rate dropped to under 5.5%, she’d consider rate hikes. Now attaining the right unemployment rate hasn’t yet translated into strong GDP growith, calling attention to the quality of employment since a strong economic recovery began in March 2010, nearly tripling the DJIA and other market indexes.
When markets bottomed March 9, 2009, the S&P 500 stood at 676 compared to Friday’s June 5 close of 2,092. Likewise, the tech-rich Nasdaq stood at 1,268 as opposed to Friday’s close at 5,068, nearly 400% higher. Yellen’s expected rate hikes promise to trim more foam off all three market indexes, should Yellen go ahead with rate hikes this Fall. Before Yellen pulls the trigger, she’ll have to be more confident that nominal GDP growth isn’t flat-lining or worse yet going negative. Since former Fed Chairman Ben Bernanke dropped rates to zero Dec. 16, 2008, the economy has had many fits-and-starts with GDP growth remaining weak. When Obama came into office Jan. 20, 2009, all major indexes neared multi-year lows, with GDP growth in negative territory, signaling recession. Bernanke’s move to slash interest rates attempted to avert what looked like another Great Depression.
Seven years later, Yellen walks a dangerous tightrope raising rates when GDP remains so sluggish. Any damage to Wall Street in the way of a major sell-off or correction would almost certainly turn GDP growth negative. Some economists see the most recent jobs report as a mixed bag, despite adding some 280,000 non-farm payroll jobs in May 2015. Given the mushrooming national debt now a $18 trillion152 billion, there’s real concern that the current $430.8 billion interest payment, based on a rate of 2.4%, could rise dramatically if Yellen goes ahead with a Federal Funds rate hike this September. Hedge, private equity and mutual funds could see massive outflows if Yellen moves ahead with rate hikes. Triggering a Wall Street sell-off could create the same kind of liquidity crisis seen in 2008 when the nation’s biggest banks ran out of cash needed to pay depositors and creditors.
Few market-makers on Wall Street go by conventional standards of valuation, including price-to-earnings ratios. Watching share prices, double, triple and, in some cases, quadruple hasn’t spooked a lot of institutional investors who kept buying into positions driving valuations through the roof. Margin debt, the amount of institutional and private stock purchases financed, hit a record of $507 billion in mid-April, signaling, if nothing else, that it’s time for a pause, maybe serious profit-taking. “There’s complacency, more complacency than I’m comfortable with. It makes me nervous,” said Leo Grohowski, chief investment officer at New York-based BNY Mellon Wealth Management. Grohowski sees an up-tick in the VIX index, a measure of market volatility. “Market participants don’t seem prepared for an up-tick in volatility, which is consistent with high levels of margin debt.”
Yellen’s public remarks about raising interest rates this Fall have caused a sell-off in the bond market, promising the do the same on Wall Street. Unless GDP growth and inflation are higher than expected, the Fed’s rate hikes can only weaken the U.S. economy. Rate hikes would dramatically increase payments on the U.S. national debt, causing a liquidity crunch at the Fed and eventually in major U.S. banks. “Margin debt is usually at record highs when markets peak, but it also usually at record highs in the months and years lead up to a market high,” said Paul Hickey of Harrison, NY Bespoke Investment Group. Given the risks to Wall Street and U.S. economy as a whole, Yellen should think twice about hiking rates unless justified by real GDP growth and inflation. With consumer spending sluggish, it’s doubtful that inflation or GDP growth will increase anytime soon.
