The New Rules of Interest Rates

Everything You Know About Interest Rates and the Economy is Wrong.

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What does it mean for the market when the Fed cuts interest rates? Historically, the Fed cuts rates to stimulate a slowing economy and pull the country out of recession. But that pattern might be different now.

In the midst of the financial crisis in late 2008, the Central Bank cut interest rates from a high of over 5% to less than 0.25%. The rate was left at Armageddon pricing for seven years in order to stimulate the post-crisis recovery, something never before attempted.

Finally, in late 2015 the Fed began raising the Fed Funds rate. As the economy gained sufficient independent traction in the middle of the decade, the Fed began raising rates to fend off inflation, prevent bubbles from forming, and get some dry powder to stimulate the economy. They pushed it back up to 2.25% to 2.50% in an attempt to “normalize” the rate for this stage in the economic cycle. After all, in every recovery since the 1960s, the Fed Funds rate had been raised to at least 5% as the economy strengthened.

Things seemed to be going according to plan.

The market was doing great—hitting new all-time highs—and the Fed had every intention of continuing the rate hikes. Then the market rebelled. It plunged 20% on fears of an imminent recession. Rate hikes were fine … and then suddenly, they weren’t. What happened?

The Fed reacted by first announcing a halt to the rate hikes and then two additional rate cuts of 0.25%.
To many, that kind of Fed reversal is a sign of a weakening economy. That should not be a surprise. In fact, it should be rather obvious: When the Federal Reserve cuts interest rates, it’s always due to economic sluggishness or “uncertainties.” In the long term, an uncertain economy is bad for the stock market. When the Fed cut rates in September 2007, when U.S. home prices fell, the first major leak before the subprime mortgage crisis dam broke, plunging the U.S. into its worst recession since the Great Depression.

But Central Banks have screwed up interest rates as a market indicator, and they are now operating in a brand new paradigm of their own making to which there is no historical precedent.

Some people fret about the potential for yield curve inversions, where long-term interest rates fall below short-term rates. To be fair, such a phenomenon has historically been reliably indicative of a slowing economy and the end of the recovery. But that’s when interest rates were a clear reflection of free market forces. Those days are over.

The good news is that rate cuts are no longer necessarily a reflection of slowing economic growth. That’s good news for stocks. And falling rates are especially good for dividend stocks.

At some point, this Central Bank experiment could end quite badly. If it does, you’ll want to hold as many safe, all-weather stocks in your portfolio as possible. Reliable dividend payers—and particularly dividend growers—are a good place to start.

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