It should now be all clear on the Western front, as some experts would like us to believe. After all, they reckon that the Fed is just about done with its rate hikes. That certainly seems plausible. The Fed fund rate is now at 5.25%, whilst the annual inflation rate stands at 5%.
So, after more a year of rate increases, the Federal Open Market Committee (FOMC) has managed to lift its benchmark interest rate above the rate of inflation. It hasn’t been easy, though. But it has been a real-time exercise in demonstrating how to boil a frog. In other words, if we put a frog in a pan of cold water, and slowly turn up the heat, our lovable amphibian shouldn’t feel too uncomfortable…. until it does.
The frog-boiling technique has certainly worked to a large extent. Apart from a slight hiccup in the pensions sector in the UK, and a handful of banks going bust in the US, the Fed’s rate-hike strategy hasn’t been too disruptive. But the next stage is when things really start to get interesting. This is when the Fed’s Quantitative Tightening (QT) policy will separate the men from the boys.
In fact, QT is part of the reason why the Fed thinks that it doesn’t need to raise interest rates further. It expects the stepwise withdrawal of cash from the economy will drain excess credit from the system. So, if we think of interest rates as a surgical scalpel, then QT could be equivalent of a rusty penknife.
In many ways, a shortage of available credit could do considerably more damage than a high cost of borrowing ever could. A credit crunch could curtail economic expansion, stunt property development, and shock many businesses into bankruptcy, as heavily indebted companies find themselves starved of cash.
This could be the long-overdue clear out that many in the market have been waiting for. Put another way, there could be casualties. They could come from any or all sectors of industry. Investors should therefore tread carefully.
Those that are susceptible include the heavily indebted; those that are unable to generate free cash, and those that are deemed in the opinion of lenders to have less than pristine risk-ratings. They could be the first to crumble in a credit crunch
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Disclosure: David Kuo does not own any of the shares mentioned.