Fed Chairman, Ben Bernanke, indicated this week that the American economy might be getting strong enough to stand on its own two feet. That led to some interesting market volatility. Stocks went down a bit (2.3%) and gold (that great risk and inflation hedge – tongue in cheek) dropped significantly (6.4%). The question is whether the optimism was too high too soon.
Here’s what’s going on:
The Fed tries to increase the amount of borrowable money when things look bad economically – more money to be borrowed equals lower interest rates (supply and demand). Increasing economic activity can lead to reductions in unemployment, which gives the workforce leverage to ask for raises. (If there aren’t willing replacements just outside the factory or company doors, then I can push for a raise without fear that I’ll be pushed out the door.) Low interest rates spur buying of expensive stuff, so eventually that leads to better economic conditions. The challenge is trying to figure out when this chain of events will start happening. Eventually interest rates will have to climb. They are usually 1 to 3% above inflation, and right now, they are negative compared to inflation. (I have a chart that I use with investors from time to time that shows the amount of time, historically, that bond yields have been negative after inflation. The frequency is much greater than people realize. That means that an increase is not necessarily imminent.) All investors (or I should say the gamblers) on Wall Street are trying to do is get ahead of a market downturn by selling. Ironically, all they end up doing, most of the time, is locking in a lower price and shooting themselves in the foot. No one has ever been able to successfully time the market over the long run, and trying has only led to lower returns and higher risk for investors.
