Most market strategists are looking at last month’s Fed funds rate hike, and mistakenly labeling it Janet’s first raise. They surmise the past three rate tightening cycles have lasted roughly one or two years, so following this line of logic, we can expect at least another twelve months of tighter monetary policy.
Have a look at the chart of Fed funds during the past three rate hike cycles:
Usually when the Fed starts a tightening campaign, it continues for at least a little while. It would be unusual for the Fed to tighten after a prolonged period of flat rates, only to quickly stop or even reverse. Yet, this what some of the more bearish managers like DoubleLine’s Jeffrey Gundlach are predicting.
Whereas many conventional thinkers dismiss Gundlach as a “90210 kush loving” weirdo (see awesome link to TCW’s suit against Gundlach)</a>, I think Jeffrey is onto something here.
And I actually think there is a way to reconcile their two lines of thinking, I just don’t think the optimists will like it.
During the 2008 credit crisis, when the Federal Reserve was constrained by the zero bound, instead of venturing into negative rates, Ben Bernanke chose to aggressively expand the Fed’s balance sheet through Quantitative Easing. This QE had the effect of easing monetary conditions without lowering the Fed Funds rate. The amount of easing is difficult to measure, but two economic professors created the Wu-Xia Shadow Fed Funds rate indicator to approximate the “equivalent” Fed funds rate.
Even though the Fed Funds rate was stuck at zero from 2008 to 2015, the Wu-Xia shadow fed funds rate moved around as Bernanke’s Fed applied varying amount of stimulus:
From 2008 to 2014 the shadow rate fell from 0% to negative 3%! Then with the tapering, and eventual cessation of QE3, the rate gradually climbed back up to 0%. This has had the effect of a 300 basis point raise in the effective fed funds rate. Combine that with the actual 25 basis points rate rise, we are 325 basis points off the lows.
Stop and think about that for a second. What if last month’s rate hike was not the first, but actually the thirteenth 25 basis point hike? And what if instead of using December 2015 as the date of the first hike, we should really be using June 2014 when the Wu-Xia Shadow Fed funds rate bottomed and started rising? That would mean we are presently already 18 months into the tightening cycle.
That would put us right in the middle of the length of the time of the past two tightening cycles. And given the fact that since the credit crisis we have increased the total amount of indebtedness, it is probably safe to err on assuming the economy is even more sensitive to rate hikes.
Therefore, Gundlach’s prediction last month’s Fed hike won’t be followed with a series of rate hikes is not that implausible. After all, if you follow the playbook that all the conventional guys are using, and adjust for the Shadow Fed Funds rate, then a finish to the rate tightening cycle would be right on time…
I am going to trade to reflect a Fed that is a year and a half into a tightening cycle, instead one that has just started.
Thanks for reading,