The U.S. Federal Reserve is set to meet this week to make what many have termed the biggest decision of the year. It has been three years now since the Fed ended the quantitative easing program created to ease the financial condition of the economy following the global financial crises of 2008-09.
In 2014, several reports termed the ending of the quantative easing as the beginning of fiscal tightening as the Fed moved to stimulate the growth of the U.S. economy. A year later, the Fed continued with its tightening measures by raising interest rates for the first time since before the financial crisis, and has since gone on to increase the rate a further three times, once in December 2016 and twice this year. Another hike is expected in December, bringing the tally to three rate hikes in 2017 and five total since December 2015.
The Fed is also expected to raise rates four times over the next two years, twice in 2018 and 2019. The quarter point mark will remain the basis of every hike, which means the U.S. funds rate could hit 2.50% within the next two years.
But before then, the Fed’s meeting on Wednesday could stoke more fears about the outlook of the U.S. economy if it continues with its plans for “reverse quantitive easing." Analysts expect the agency to announce a new program aimed at reducing the $4.4 trillion worth of balance sheet assets.
When you combine this initiative with another rate hike at the end of the year, this will take the Fed’s tightening of the fiscal policy to another level. Even though the inflation rate has failed to meet the Fed’s targets, this suggests the labor market could be painting a false picture based on the most recent jobs numbers.
The unemployment rate remains at multiyear lows of 4.4% and non-farm payrolls continue to impress month after month. One major key indicator, however, has consistently been undershooting expectations.
The increased tightening is expected to continue significantly influencing short-term lending rates, which could have a major impact on small businesses looking to grow their operations through credit financing. Therefore, it would be advisable to opt for fixed rates for those looking to open a new business line of credit going forward because the number of rate hikes could increase to nine in just over four years, reflecting about a 2.25% increase in the base funds rate since December 2015.
The implications on floating rate loans could be significant and there are no indications interest rates could drop in the foreseeable future.
Who is likely to benefit from the rapid increase of the funds rate?
Warren Buffett (Trades, Portfolio) is a known admirer of high interest rates. He is one of the largest investors in bonds and bank stocks through his company Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial). As of 2017, Berkshire Hathaway has more than $85 billion in cash invested primarily in short-term Treasuries. According to analysts, a 1% increase in interest rates would lead to a $885 million increase in Berkshire's income per year.
In addition, Buffett continues to gain from his investments in bank stocks. Wells Fargo (WFC, Financial) is one of Berkshire’s largest investments with more than 500 million shares. Therefore, any significant movement in Wells Fargo’s bottom line due to increased interest rates is likely to boost the value of Berkshire Hathaway’s ownership in the stock.
Berkshire Hathaway is also renowned for its investment in insurance companies. Higher interest rates are also good for insurance companies because they continuously receive cash in the form of premiums, but do not pay out claims concurrently. So their cash inflows are more frequent than outflows.
As such, they tend to hold a lot of cash, financially referred to as float, which they then invest in liquid instruments like short-term debt. As mentioned earlier, short-term debt reflects every hike in the funds rate almost immediately compared to long-term debt.
For borrowers, increased rates usually have a negative impact. For lenders, however, the impact is positive and benefits those investing in short-term debt.
Disclosure: I have no positions in any stocks mentioned in this article.
