More Rates Hikes and a Very Soft Economy Ahead

According to yesterday’s interest rate futures, it’s now a 94% chance the Federal Reserve will raise interest rates another quarter point on March 28, bringing the Fed’s benchmark rate to 4.75 percent. And, while only a couple of weeks ago market watchers all thought this coming rate hike would be the last in the cycle, traders are now starting to speculate on another increase after March.

The futures market now indicates traders are about 50/50 split on an additional rate increase by the Fed at its May meeting. Some 56% of traders believe the Fed will raise the benchmark Federal Funds Rated to 5 percent on May 10.

While I wouldn’t cement another rate increase in May just yet, it could likely happen. Why? Because the Fed always goes too far in its interest rate cycles. When rates were brought down by the Fed after 9/11, no one at that time thought interest rates would fall to a 46-year low of 1 percent.

If you study the Fed cycles, you can easily see the Fed usually goes too far lowering or raising interest rates once a cycle begins. Hence, I would not be surprised to see a rate hike in May (barring a jump in the unemployment rate).

Why do I spend so much time analyzing and watching the Fed’s actions on interest rates? Simply since the level of interest rates is the single most important factor affecting investments and our economy. When the Federal Funds Rate fell to 1 percent in the summer of 2004, which I thought was a mistake, consumers were able to afford bigger and better first, second, and third homes. So the real estate market took off and so did job creation and the economy.

I believe very few consumers fully understand the ramifications of the Federal Funds Rate now moving close to 5 percent–a 400% jump in less than two years. When you take into consideration that about 30% to 50% (depending on what reports you believe) of all U.S. mortgages are variable rate mortgages, the borrowing costs of consumers are literally skyrocketing. And that’s bad news for housing and for the economy. Don’t believe me? Just look at the Dow Jones U.S. Home Construction Index (comprised of the largest home builders in the U.S.). This bellwether index is down 15.4% in the last month alone!

In the same way that lower rates brought great news to the real estate market and the economy, the current level of interest rates (having risen so aggressively), in due course, will spell big trouble for the housing market and the economy.