Imagine you were in a terrible car accident in the mid 1990s and spent the last two decades in a coma. Upon awakening, your first questions are how the economy and markets are doing. Your family, perplexed at your questions, nonetheless proceed to answer.
“What does GDP growth look like?” you ask.
“We are running between 1.50% and 3% over the past 5 years” they reply.
“What does the unemployment picture look like?”
“There was a little scare a half dozen years ago with the credit crisis of 2008,” they explain, “but it has been steadily improving since then. The latest report had the US economy running with a 5.57% unemployment rate.”
“That’s not too bad,” you say. “How has the stock market been doing?”
“For the past six years it has been going straight up. It up more than 200% during this time.”
“Holy shit. That’s one smoking market. The Fed must be panicking. Where are Fed Funds? 5%? 6%?”
“No,” they answer, and then there is a long pause.
“Higher?” you ask.
“Nope,” they quietly explain, “they are 0%. They have been at zero for the last six years.”
“Let me get this straight, the economy has been experiencing positive growth for the last six years, unemployment is 5.5% and the stock market is up 200% over this period, but the Fed still has a zero rate?”
“Yup, that’s about right,” they respond. “I guess there never seemed to be a good time to raise them back up.”
Fed meeting minutes
Yesterday’s release of the Fed minutes left the market a little confused. The initial headlines seemed to rule out a June hike, which were interpreted dovishly. Upon further review, the committee seemed to be leaning towards a September hike, but did not rule out a June hike which then caused the dovish reaction to be retraced. At the end of the day, the market was thoroughly mystified as to what the Fed was thinking. By the end of the trading session, the consensus seemed to be the Fed didn’t have a clue what was going on with the economy.
It is sad we have become so dependent on analyzing the thinking of a group of ivory tower academics who are in charge of setting the interest rate for an ever more monetary stimulus dependant economy. Twenty years ago, stock traders barely knew what Fed Funds were, forget about understanding the intricacies of quantitative easing and other obscure monetary policy tools. Today Fed policy is all that matters.
The confidence in Central Banks
The scariest part of this whole perverse scenario is the confidence the markets have in the Federal Reserve. Whether it is belief the Fed will be able to keep financial asset prices aloft and deftly manage an eventual tightening. Or the trust the Fed will be able to manage any uptick in inflation.
I don’t share the market’s confidence in the Federal Reserve and the other Central Banks. David Einhorn’s $250,000 Ben Bernanke lunch conclusion constantly rings in my head. After having a private meeting with Bernanke, Einhorn determined the Fed didn’t have a long term plan, and was simply putting out the most immediate fire.
This is the reason the market is so confused by the Fed’s minutes. The Fed doesn’t really have a plan. They want to raise rates, but are too scared. The moment the market reacts to a tightening, either through a rise in the US dollar or an increase in rates, the Fed withdraws their commitment. In the mean time, the market continues merrily along, impervious to the dangerous course the Fed has set.
However, by being so mopey, the Fed has made the situation infinitely worse. The market is rightly skeptical of any promise to raise rates. Have a look at the infamous Dot Plots from the Federal Reserve’s communications.
The red line is the market inferred future rate of Fed Funds. The other lines represent the Fed officials’ median forecast over the past six months.
The median forecast has been consistently moving lower. As the time to raise rates has approached, Fed officials have, instead of raising rates, chosen to lower their forecast.
The other interesting part of this chart is the fact the market is pricing future Fed Funds rate below almost all Fed officials forecasts (the blue dots). In fact, for 2017 there is not a single Fed official that thinks the Fed Funds rate will be as low as the market expects.
The market refuses to believe
The market refuses to believe the Fed has the nerve to follow through with what they are saying.
This will make the eventual rate hike all the more volatile.
The Fed can’t even manage the short run
Increasingly the Fed cannot even manage the short run, forget about the long run. They are clueless and only know one solution to all their problems. The insane amount of monetary stimulus that has been applied to the economy has created a situation where, over the long run, the Fed can only do more. Any serious withdrawal will cause a decline in financial asset prices which will sink the economy.
Oh, they will try to pull back. But at the first sign of trouble, they will quickly throw some more fuel on the fire.
There will be fireworks as the Fed attempts their rate hikes, but make no mistake, in the long run, their mistake will not be too little stimulus. They will eventually print so much that inflation takes off and there will be no stopping it.
It is ironic that after the 2005 real estate bubble all the market commentators laid the blame at Greenspan’s feet, proclaiming that he left rates too low for too long. Yet here we are, still at zero some six years after the emergency rate of zero was put in place.
The Fed has put itself into a box that might as well just be lowered into the ground because it is a casket. There is no way out. They are losing control, and we are getting closer to a point where the market realizes it is bigger than the Fed. The end game will be when the long end of the bond market completely loses faith.
The only question is whether a rate hike causes the financial markets to crash, which then causes the Fed to panic with more stimulus. Or whether the Fed raises rates, but it is too little too late, and the mind boggling large amount of monetary stimulus catches fire and the Fed spends the next decade desperately trying to put out the fire with their garden hose.
Thanks for reading,