Are We Ready for a Rate Hike?

The Fed is meeting next week in order to discuss raising interest rates. Interest rates have been at record lows for the longest period of time in American history.

Here is the dilemma behind raising interest rates:

WHY NOT TO RAISE: If the Fed raises rates to soon, emerging markets could plunge, economic momentum could fade and hopes for better paying jobs could evaporate. We are currently in the midst of global economic turmoil. China has just devalued it's currency due to slow domestic economic growth, emerging markets's Gross Domestic Product is declining, the dollar is increasingly getting stronger and there is deflationary fears in Europe. If the Fed raises interest rates now, the dollar will only get stronger which in turn, would hamper U.S growth and exports. Because Emerging Markets all have borrowed trillions of dollars in the last few years, they will now face an increase in the real local-currency value of these debts, while rising US rates will push emerging markets’ domestic interest rates higher, thus increasing debt-service costs further.

Low borrowing costs induce wage growth but that has not been the case. Average hourly earnings rose by only .3 percentage points in August according to the most recent jobs report. The World Bank's current chief economist, Kaushik Basu warned, and quote, "The world economy is looking so troubled that if the US goes in for a very quick move in the middle of this I feel it is going to affect countries quite badly,”


WHY TO RAISE: If the Fed waits to long to raise rates, they run the risk of driving inflation. Unemployment is down to 5.1% which is in the "rate hike target zone." Creditors have been working with slim net interest margins that have been barely covering inflation risk. A lot of creditors do not want to lend. This slows down economic growth which is counterintuitive to having low interest rates in the first place. We are in unchartered territory maintaining low rates. if rates rise and the dollar becomes strong, America will import more goods from emerging markets which will boost their GDP. Only time will tell what the correct move will be.


HOW RAISING RATES IMPACT THE DOLLAR: As rates rise, the dollar strengthens and vice versa.  When the dollar is strong, we tend to import more (foreign goods are cheaper. More bang for your buck). If you import more than you export, you have a trade deficit.

As rates rise, foreign investors buy dollars because dollars will earn higher returns. But if the dollars get to strong and is not subject to inflation, the dollar will experience deflation. Economists believe deflation is a problem because it increases the real value of debt, which in turn induces recessions and launches deflationary spirals.

HOW RAISING RATES IMPACT PRIVATE EQUITY: Private Equity firms have 2 main investment strategies: Venture Capital and Leveraged Buyouts.

When conducting a leveraged buyout, PE firms rely on using debt in order to meet the cost of acquisition. This type of investment requires steady cash outflow in the form of interest payments. The IRR the PE company uses when it exits a deal depends on the interest rate when it took on the debt.

As interest rates rise, investors flock to fixed income and credit securities. PE fundraising becomes difficult. During a rate hike, assets are devalued. There is no more easy money and demand is low for assets. This proves a great time for PE firms to buy undervalued companies.

On the other hand, IPOs boom during low interest rates and there is high demand for assets. This is a great time for PE firms to exit deals when prices are high.

HOW RAISING RATES IMPACT EQUITIES: Rising interest rates mean banks charge businesses more to borrow capital and take out debt. This slows down enterprise expansion and decreases future cash flow expectations by investors. In addition, a higher interest rate means investors will transfer their funds out of equities. In other words, stock prices fall.

But that is only true in very broad terms. Every business varies regarding consumer behavior and revenue streams. During low interest rate periods, luxury companies prosper due to cheap credit. In high interest rate periods, banks and insurance companies prosper. Their net interest margin spread widen and a healthy economy could foster credit growth. The financial sector has little exposure to the rising dollar and could potentially produce the most growth in shareholder return. A good example is Bank of America.