There is no doubt that the markets are tricky to navigate these days. There are many different cross currents that are making the waters especially treacherous.
Will the poor world economic growth continue for the rest of 2014? Is the Fed behind the curve and poised to raise rates any moment now? Maybe the Fed is going to take more of a slow gradual approach to tightening? Will the end of the QE program mean lower stock prices like the two previous QE programs? Or has the economy finally achieved a self sustaining escape velocity? Will the improving employment market ever translate into higher wages?
What I find most interesting about the current environment is that most market participants are quite pessimistic about the economic outlook. Yet at the same time, they are confident that financial assets will continue to chug higher. The overwhelming consensus is that GDP will continue to disappoint, yet corporate profits will be able to grow all the while interest rates stay low.
Ever since the stormy days of the 2008 credit crisis, the Fed has force fed money into the system. Although that injection has stabilized the financial markets, the economic rebound has been tepid when compared to previous recoveries. As the Fed has stepped on the gas pedal, the benefits from the monetary expansion have been contained to financial assets. Most of the effects have been felt in higher equity prices and lower risk premiums for other financial instruments. The economic benefits from the Fed’s largess have not trickled down outside the financial economy in any meaningful way.
The market, in its typical myopic fashion, has done nothing more than extrapolate that trend. The consensus that companies will continue to experience outsize gains due to an ever accommodative Fed is all that most market participants can imagine.
I can understand why this consensus belief is so firmly held. Betting against this trend has been a mugs game. Those that have been seduced by the dark side in their outlook for financial assets (be it stocks, bonds, spreads, or volatility) have fallen flat on their face.
Assuming that the economic recovery will spread to the real economy has been a terrible bet. Assuming that the Fed will slow down their propping up of financial assets has been equally stupid.
So we are now at a point where the market can do nothing more than imagine more of the same. This is an extremely dangerous position for the Fed to be in.
Apart from a deflationary spiral that they cannot arrest, this is probably their next worst nightmare. An inability of their expansionary policies to create economic growth is what the Fed dreads. They are in essence pushing on a string with their policies.
Actually it is even worse than that. As they force feed money into the system, it is concentrating in higher prices for financial assets. This is causing the inequality problem between the wealthy and the lower classes to get all the worse.
The Fed would welcome general price inflation – that would lower the general level of indebtedness. But having monetary expansion concentrate itself in financial assets does little to help the average American. It simply raises the risks to the financial system as financial assets prices and leverage soars.
Which brings me back to all the cross currents that we are in midst of battling. The Fed recognizes the problems with their policies, but given the high level of indebtedness, they are loathe to trigger the next deflationary decline. So they are struggling with how to wean the market off their policies. But the longer they take, the more that the market believes that the Fed doesn’t have the stomach to actually pull the trigger. Which makes the current trend only accelerate further – making the cost of the Fed actually changing policy all the greater, which only emboldens the market to push asset prices even higher. It is a very unstable equilibrium.
Don’t believe me that the market is skeptical about the Fed raising rates? Have a look at this chart of the implicit forward interest rate versus the Fed’s “plots” about the expected course of interest rates:
The curve is trading below where the Fed is forecasting future rates.
In essence the market does not believe the Fed is as serious about raising rates as they forecast.
Which is quite unusual because it was less than a year ago that the Fed was struggling with a market that had quickly assumed “tapering was tightening.” In that debacle, the curve backed up so quickly that Bernanke had to delay the tapering. The next time they signalled tapering, the Fed went on a campaign to stress that “tapering was not tightening.” It looks like the Fed might have done too good a job because they now have the opposite problem. The market is refusing to believe that the Fed has the stomach to raise rates as much as they forecast.
Although the economy is not as strong as the Fed would like, rates are still zero and that rate is not the proper price for an economy five years out of a credit crisis. Not only that, but the economy is slowly improving and indicators like yesterday’s jobless claims are at levels inconsistent with a zero Fed Funds rate.
US Initial Jobless Claims</a> </div>
The last time that Initial Jobless claims were at this level Fed Funds were trading over 4%!
Claims (white line) and Fed Funds (yellow line)</a> </div>
I know that there is a lot more to the employment picture than just initial jobless claims, but there is no doubt that Fed policy is extremely accommodative. Have a look at this Taylor model for Fed Funds:
You can quibble about the inputs, but there is no denying that most economic models indicate the Fed should have raised rates long ago! I guess it should be no surprise that financial assets are exploding to the upside. The Fed is once again keeping rates too low for too long – the exact same thing that all the pundits lambasted Greenspan for doing in the mid 2000s. That resulted in a massive real estate bubble that ultimately caused a tremendous amount of pain. This period of excessively easy monetary policy will also have costs that we don’t yet recognize.
In the mean time, we are hitting a point where even the most dovish Fed in history is worried about the market’s complacency regarding their willingness to raise rates. I know that there are a lot of mixed signals out there and that the economy is not robust by any means. But I believe we have hit a point where the Fed is going to get more assertive in their hawkishness.
I don’t think the Fed wants the market to be even more dovish than their guidance. All these different forces are pushing and pulling in various directions, but at the end of the day, the Fed has to wean the markets off the zero interest rate policy. The fact that the market is behind the Fed’s projected interest rate curve, which is already way behind the economic model interest rate forecast is all the more frightening. The potential for a big selloff in all financial assets as the Fed tries to normalize interest rates is much higher than most market participants realize.