This may sound like a slightly over the top idea for some, but its important that investors pay attention: there could be major financial crisis looming. This time around, it could be worse than the last one.
What will cause this financial crisis? It’s important to pay attention to the chart below. It plots the federal funds rate–interest rates set by the Federal Reserve.
Chart Courtesy of StockCharts.com
Look at the rectangles drawn on the chart. Whenever the Federal Reserve has raised rates after keeping them low for a while, a major bubble has formed. Eventually, these bubbles burst and end up as full-on economic or financial crises.
In 1994, the Fed starting to raise rates, and didn’t really stop till 2000. In the midst of all his, we had the dotcom bubble forming. Those who were invested in the markets know very well how it ended. The Federal Reserve raised the federal funds rate from three percent to six percent.
Then, in 2004, the Federal Reserve decided to raise interest rates again, stopping in early 2007. Rates went from around one percent to four percent. During this time, we had the housing bubble getting bigger. It was followed by one of the biggest financial crises. If you recall, when a housing bubble bursts, the entire financial system was one verge of collapse.
So, What’s Next?
In case you didn’t know, the Federal Reserve is raising interest rates after keeping them at zero for about six years. By 2020, the federal fund rate is expected to be around three percent. The “X” on the chart above represents this.
Do we have any bubbles forming? Yes.
As it stands, we have the stock market trading at extremely high valuations. For instance, look at the CAPE ratio; it’s the price-to-earnings (P/E) ratio adjusted for cyclicality and inflation. The ratio stands at the highest level since the dotcom bubble. It has to be questioned if there could be a stock market crash and if it could lead to a financial crisis.
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