Way back when, when interest rates went up as well as down, one of the earliest Wall Street technical analysts came up with “three steps and a stumble” adage to describe the stock market’s tendency to decline following the third Fed interest rate hike. A Leuthold Group study showed that during the second half of the 20th century, stocks lost an average 2.7% in the year following the third Fed rate hike.

You might be saying, “So what? We haven’t even gotten the first tightening, so why does this matter?”

But like so many other things in this topsy turvy world of insane monetary policy, I believe the rules have changed. In 2008 when the Federal Reserve became limited by the zero bound, Bernanke came up with novel new ways to expand monetary conditions. The Federal Reserve instituted a series of quantitative easing programs, along with another program to change the duration of their balance sheet (Operation Twist), to ease monetary policy. You might argue the effectiveness of these programs, but there can be no denying their accommodative nature.

Although Fed Funds were locked at zero, monetary policy varied depending on the amount of stimulus Bernanke & Co. applied via the various programs. Measuring the degree of this stimulus was not an easy task.

In 1995, while suffering from terminal cancer, legendary economics professor Fischer Black submitted a paper to the Journal of Finance that introduced a new way of calculating a shadow rate when Fed Funds were zero bound. For more than a decade the theory lay in relative obscurity. Until the 2008 credit crisis hit…

Using Black’s initial ideas, Jing Cyntia Wu, an assistant professor of econometrics and statistics at Chicago Booth and Fan Dora Xia, a graduate student of University of California San Diego created the “Wu-Xia Shadow Funds Rate.” The math is mind numbing, and I am not sure I agree with some of their assumptions as they assume a certain amount of market efficiency that I have learned over the years is often sorely missing, but given the lack of any other indicator, their work has become the standard method of measuring effective Fed Fund levels when bound by zero.

So let’s have a look at the “Wu-Xia Shadow Fed Funds rate” over the past cycle:

During most of 2009 to 2013, the shadow rate drifted around negative 1.5%. But with the introduction of the third QE program (dubbed QE infinity by the cynics), the rate dove deeply negative to –3%.

However, since the taper of the QE program, and with the eventual termination of all easing, the “Wu-Xia shadow fed funds rate” has risen from –3% to –0.5%.

The market pundits who claim the Federal Reserve has not even started raising rates are wrong. They are being fooled by the fact the Fed Funds was zero bound. Even though Fed Funds were stuck at zero for the past six years, the effective rate was much lower. Now that this rate is being pulled back up to zero, and if the Federal Reserve hikes this December, will cross back to positive, the effective rate will have risen by more than 3% in the space of a little more than a year.

It is no wonder the US dollar is soaring, the economy slowing down, and the stock market stopped rising. Monetary conditions have been tightening.

The only question is how much tightening is required before a real stumble in the stock market?

I know this is arbitrary, but what if the taper was the first step, the termination of the QE programs was the second, and the actual move off of zero the third?

My guess is the “three steps and a stumble” is still relevant. You just need to be careful what you define as a step…

Thanks for reading,

Kevin Muir

the MacroTourist