Last Thursday after the markets closed, Fed Chairwoman Janet Yellen made a speech that reassured markets the FOMC committee was on a path to raise rates in 2015.
Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
This was a much different tone than Yellen struck at the previous week’s September FOMC meeting when the Federal Reserve passed on raising rates. On that day, news the Fed would delay the start of the rate tightening cycle caused the stock market to initially spike higher, but then sold off relentlessly for the next week.
Monetary hawks interpreted the reaction as a signal the Federal Reserve had “lost control” of the markets. These pundits argued the market actually wants the Fed to raise rates, and that waiting is causing markets to sell off.
This is why Thursday’s subsequent hawkish Yellen speech caused the S&P 500 to rally 50 handles off the lows. The perverse trading logic reasoned that if the markets plummeted 110 big figures because the Fed didn’t tighten rates, then surely putting monetary policy back on a tightening path would cause these losses to be regained.
When I saw the rally after Yellen’s speech, I had to rub my eyes. I couldn’t believe the foolishness of chasing stocks on the idea the Fed was turning more hawkish.
Many smart guys argue the US economy can handle higher rates, and that it might even be good for risk assets. Famed hedge fund manager Leon Cooperman summed up this line of thinking:
“On average, after the first Fed tightening one year later, the market is higher by an average of a little under 10%. And I think the initial stage of rising interest rates are indicative of an improving economy, rising earnings, rising dividends — and the market likes that,” he said.
Far be it for me to fade Cooperman, but I respectfully disagree with his analysis. Usually the Federal Reserve starts hiking rates into an improving economy. There has never been a Fed rate rise campaign started with inflation running below their target level. Yet even though the US and global economy is rolling over, with inflation significantly below target, the Federal Reserve continues to threaten to raise rates. This is a dramatically different environment than the previous rate tightening cycles Cooperman is using as a guide.
Ever since the 2008 credit crisis, every Central Banking mistake has been overestimating the strength of the recovery. Too many Central Banks have raised rates only to find their economy collapse, and these hawkish CBs were quickly forced to lower rates back down. From the WSJ:
This is not the same type of recovery Cooperman has experienced over his long career. This balance sheet recession means all previous play books should be thrown out the window.
You might argue they should raise rates anyway. I will not defend the overly easy monetary policy. Yet to reason raising rates will somehow be good for risk assets is just naive.
Many hawkish pundits believe the Fed is holding down interest rates at unnaturally low levels. Their line of reasoning is that if the Fed were to allow rates to rise, the economy would be better able to function. But if the Fed were holding rates below the clearing level of rates, wouldn’t inflation be taking off? I stumbled upon this great post from former University of Chicago economics professor John Cochrane:
The central point came to me hours later, as it usually does. Is the Fed in fact “holding down” interest rates? Is there some sort of natural market equilibrium that features higher rates now, but the Fed is pushing down rates? That’s the conventional view, clearly expressed in Mary’s questions.
Well, let’s think about that. If a central bank were holding down rates, what would it do? Answer, it would lend a lot of money at low rates. Money would be flowing out the discount window (that’s where the Fed lends to banks), to banks, and through banks to the rest of the economy, flooding the place with low-rate loans. The interest rate the Fed pays on reserves and banks pay to borrow from the Fed would be low compared to market rates; credit and term spreads would be large, as the Fed would be trying to drag down those market rates.
That is, of course, the exact opposite of what’s happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.
If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.
Now some would argue there is inflation, it is simply in financial asset prices. There is some truth to that idea. The Federal Reserve cannot control where the stimulus goes.
But that stimulus is being withdrawn. The Federal Reserve has stopped expanding its balance sheet, they have begun slowly withdrawing reserves with reverse repos, and they are now readying the market for the first interest rate hike in almost a decade. All these factors have already caused the US dollar to run like it stole something.
The US dollar is signalling that policy is too tight. The American economy cannot handle a continually strengthening dollar. Not only does this currency strength crimp US growth, but it is a huge anchor around the neck of the global economy.
Too many countries have soft pegs to the US dollar with the elephant in the room being China. When you combine that with the huge amount of borrowing in US dollars that was done when QE1, QE2 and QE3 programs were pushing US dollar liquidity into the global financial system, you have the recipe for any US dollar strength to quickly snuff out any global recovery.
The Federal Reserve has traditionally viewed the global economy as not part of their mandate. Yellen has recently acknowledged the larger role global economic conditions are playing in their deliberations, but at the end of the day, the Federal Reserve will tune monetary policy for the US, not for the world.
Unfortunately the Fed is obsessed with the apparent tightness of the labour market and its potential to spill into inflation. They still believe the Phillips curve will ultimately prove correct. Although the Federal Reserve is nervous about the global economy, they are sticking to the idea it is time to raise rates.
Maybe they are right, I don’t know. But the key point is that no one else knows either. The only thing I am sure of is that in this era, rate rises are not positive for risk assets. The idea that you should buy spooz because Yellen is willing to raise rates is just dumb.
In previous cycles, the stock market went up during the initial stage of rate hikes, not because of the hikes, but in spite of them. The economy was simply so strong that the initial raising of rates was not enough to slow down the economy. This is not the case today.
So when they bid up stocks on hawkish Federal Reserve talk, you shouldn’t bother arguing with the hawks, instead simply put your palms out and say SOLD TO YOU.
Thanks for reading,