What the Coming Rate Hikes Will Actually Mean

In Blackrock's latest weekly commentary, Russ Koesterich discusses the subject of a rise in interest rates, which he says is likely to come "sooner than expected." Koesterich goes on to list three things that are likely to happen in the event of a rate increase, two of which I disagree with (I'll explain why in a minute). Either way, it is my guess that most people will accept Koesterich's view on the effects of rising rates, because they happen to be widely held beliefs -- though wrong -- and they'll position themselves accordingly and lose money in the process.

Koesterich's analysis is based on the same faulty understanding of monetary policy and its effects that got so many people to buy gold and sell U.S. Treasuries thanks to all those wild "inflation calls" following the onset of the Federal Reserve's quantitative-easing program. The entire mainstream economics community had that wrong, and there are still members of that community hawking the same line today, which to me is beyond laughable.

So here goes.

The author says that, in the event of a rate hike, investors should expect three things to happen. One, the dollar would rally. Two, short-term Treasury securities would experience higher volatility -- a euphemism for "underperform," or go down. Three, gold would come under pressure.

I disagree with the first and the third notions.

The one that this guy gets right: A rate hike will cause short-term instruments to sell off. Well, yes, that is obviously true, and I am glad the author at least understands this. Interest rates and bond prices move inversely to one another by definition, so if the Fed is hiking rates short-term instruments will certainly go down.

While Koesterich doesn't explicitly say this, long-term Treasuries might sell off, too, because the Fed may, in its language, give indications that a rising-rate policy will remain in effect for some time. Since long-term rates are nothing more than Fed-policy expectations over the term, long-term Treasuries may therefore go down as well. Koesterich calls all of this "volatility" -- but, like I said, that is simply a euphemism for Treasuries selling off.

Now, let's address the two points that I disagree with. In fact, I will come right out and say it that his gold and dollar predictions won't happen. They'll do the opposite. Gold will go up on a rate hike, and the dollar will go down.

What Koesterich misses, and what all of mainstream economics missed during the entire period of QE, was this: Since the government is a net payer of interest, the real impact of rate hikes or rate cuts is simply that they add or subtract from net income in the economy.

In the case of a rate hike, net income is increased because it raises the level of fiscal injections into the economy -- the government pays more interest -- without a concomitant increase in the level of output. Oftentimes, in fact, this even spurs a decrease in the level of output. Therefore, a rate hike is inflationary, not deflationary.

This means more dollars created without a corresponding increase in the level of goods and services being produced. That is the classic definition of inflation. It is not dollar-bullish, nor is it gold-bearish. It is the opposite. So you can be sure that, when the Fed hikes rates, after that initial knee-jerk reaction when everyone buys the dollar and sells gold, I will be doing just the opposite and riding that position all the way to the bank.

At the time of publication, Norman had no positions in the securities mentioned.