This Friday morning, die-hard Star Wars fans will awaken to a powerful force that hasn’t been felt in theaters for a decade – a new installment to the iconic franchise. For the seventh time, moviegoers will turn out in droves to watch Jedi knights, storm troopers, and all kinds of alien beings fight for galactic dominance. If history is any guide, the theaters will be filled with patrons sporting Darth Vader masks, Obi-Wan Kenobi beards, and even styling Princess Leia’s bagel-sized hair buns.
Despite the anticipation, no long-time fan of the franchise goes into Friday without a healthy amount of trepidation. For while the first trilogy received rave reviews at the time and lives on in treasured popular memory (with a stunning Rotten Tomatoes average of 96%), the second (prequel) trilogy stumbled badly (with a middling Rotten Tomatoes average of 61%), prompting MIT professor Junot Díaz to tell the WSJ that it “proved you could, in fact, retroactively damage a pop-cultural masterpiece.” Yet most ticketholders are choosing to live in hope, as many beloved characters from the original films – Han Solo, Princess Leia, Chewbacca, and the droids – return, while the most regrettable element from the prequels, the repugnant Jar Jar Binks, is consigned to the trash compactors of history.
Of course, there’s another powerful, pervasive force that might be felt this week, also for the first time in nearly a decade: a rise in the federal funds rate. Doubtless to avoid any risk of missing the Star Wars premiere on Friday, the Fed’s rate-setters plan to meet on Wednesday, and Fed fund futures show a 79.4% market-implied probability that they’ll raise the target rate that day. To welcome the rate rise, perhaps we’ll see finance enthusiasts outside the Fed sporting Volcker masks, Bernanke beards, or even Yellen’s understated coiffure.
Despite the anticipation that follows the first potential rate rise in nearly a decade, no long-time watcher of financial markets goes into Wednesday without a healthy amount of trepidation. This is because there’s a trilogy (at least) of big concerns.
(IV) Star Wars. Some of the stars of financial policy advocacy are taking strong stances as the meeting date approaches. Paul Krugman, in his “Hike They Shouldn’t” blog post last month, noted that wage growth is still below crisis levels, core inflation is still below the Fed’s target, and world economic weakness will be imported to us via a strong dollar. On the other side, Bill Gross states that artificially low interest rates “keep alive zombie corporations that are unproductive; destroy business models such as insurance companies and pension funds because yields are too low to pay promised benefits; turn savers into financial eunuchs, unable to reproduce and grow their retirement funds to maintain expected future lifestyles.” So how will these financial star wars resolve themselves, with the concerns of sluggish wage growth and global weakness auguring for one course, while insurance & pension viability and the plight of fixed-income savers argue for the other?
(V) The Fed Hike Strikes Back. While the initial rate rise in December is both confirmed by FOMC member statements and priced into futures markets on Fed funds, the projected paths of interest rates after that diverge. An analysis conducted last month showed the 3-month LIBOR forward curve considerably undershooting the average view of Fed Funds targets among FOMC members, constituting a gap of 125 basis points by three years. This implies that the market or the Fed will have to adjust expectations substantially. So will market sentiment priced into the more gradual forward curve prevail, or will the Fed hike back with faster, stronger force?
(VI) Return of the Jobs? Much of the discussion around the appropriate timing of interest rate hikes centers around the job market. While the topline unemployment number of 5% remains strong, the labor force participation rate of 62.5% hasn’t been this low since 1978 (around the first time Star Wars was in the theater!), and the 25-54 labor force participation rate matches the Return of the Jedi era. The variance in job market indicators makes it challenging to get a clear read on medium-term prospects. Additionally, there are some who argue that raising interest rates, by encouraging productive investment rather than zero-rate-financed buybacks and dividends, would help with job creation. (Think of all the infrastructure jobs created in constructing a Death Star!) In any case, the future path of interest rates will certainly be driven by this vital question: how can monetary policy encourage the return of the jobs?
There’s a lot of drama ahead this week, both on and off the silver screen. Unless you’re a prescient Yoda figure, volatile borrowing rates can mean considerable variability to financial budgets, profitability, and returns in the years ahead. If you’d like to talk about how to remove some drama through suitable risk management, give us a call! And may the hedge be with you … always.