I find too many traders spend far too long discussing what should be instead of what is. A trader’s opinion is like the claim from an elderly grandmother that she was once quite a dish – it might be true, but it really doesn’t do anything for you. Instead of arguing about what the Fed should do, I would much rather spend that time figuring out what they will do.
To help me understand what is going on through the FOMC members’ minds, I read former Texas Fed President Bob McTeer’s blog religiously.
Yesterday he wrote a piece titled November Jobs Report Seals the Deal for December Lift-Off. Bob argues a Fed hike at the next meeting December 16th is a done deal. That’s hardly original thinking. But let’s dig a little deeper into his piece:
Given the strong hints of a December beginning of interest-rate normalization in her Washington Economics Club Speech on Wednesday and her Congressional testimony yesterday, Chairman Yellen can hardly back out after today’s good jobs report. Data dependent means data dependent.
I’m all for it even though the data probably isn’t as good now as it was a few months ago in terms of momentum. Sure, we now have two months of 5% unemployment under our belts, but momentum was probably stronger earlier. The recent further increases in the dollar exchange rate, the slowing of global trade, the dicey situation many of our trading partners find themselves in, weakening exports, and, yes, signs of slowing manufacturing don’t provide the ideal backdrop for what the market apparently sees as a major tightening. My attitude: Better late than never.
I don’t get the markets lately. Whatever happened to news being priced in so that it causes hardly a ripple when expectations pan out? That pattern still makes sense to me. Yet, it seems like each new hint of the same thing has triggered further selling. Take yesterday for example. The hints yesterday in Congressional testimony were similar to the hints the day before in the speech. Yet the stock market took a big hit.
It’s that last point I would like to focus on. Bob is bewildered by the stock market’s negative reaction to confirmation Yellen is on track for a rate hike next week.
I am not so confused by the stock market’s reaction. Since the 2008 credit crisis, the stock market has been driven by the expansion of the Fed’s balance sheet.
It wasn’t long ago that all of us traders followed the Fed’s monetization schedule closely (the infamous POMO days). On the days with larger bond purchases, the stock market dramatically outperformed the average day. I have zero doubt the Fed’s quantitative easing programs affected the stock market. The only question is to what degree?
The economic optimists will argue the effect was small. I happen to not agree, and fall into the camp who believe the Fed’s program was the driving factor of the stock market’s terrific performance during the past six years.
Bob McTeer is startled the stock market is reacting poorly to the Fed’s indicated rate hike. This surprise is easy to explain – he is playing by the old rule book, along with all the other current FOMC members. Now maybe they will be right. Maybe it isn’t different this time. Maybe the economy, and risk assets can handle higher rates.
However let’s not forget that although the Fed’s balance sheet has stayed stagnant recently, to raise rates the Fed will have to hike the Interest on Reserves rate, but more importantly, also engage in reverse repos and offer auction term deposits. Although the Fed’s balance sheet will not decline, the effect of these actions will accomplish the same thing. The Fed will not be selling, but offering their own instruments which will have the same effect.
We will have to subtract the Fed’s new found tightening instruments from the total level of the balance sheet when examining this relationship between risk assets and the Fed’s balance sheet.
Nordea’s Martin Enlund has already created a chart that shows the tightening levels (it’s unfortunately a few months old):
You will notice the spikes higher in the lower half of the chart that indicate Fed tightening are often followed quickly by stock market dips.
So far those tightening periods were just tests by the Federal Reserve. They wanted to make sure the programs were operational before they raised rates.
After December 16th those programs will be kicked up a notch. To think that it won’t have a negative effect on the stock market is naive.
When Bernanke instituted QE, one of the benefits he touted was higher equity prices. The Federal Reserve can’t have it both ways. If QE was stock market positive, reverse QE through repos and auction securities will be stock market negative.
I think too many FOMC members have forgotten this simple fact…
Thanks for reading,