Quarterly Newsletter-January 2019
You Know You Want to Read about the Fed
The U.S. Federal Reserve Bank was founded over 100 years ago. It has a dual mandate of assisting the economy with full employment and striving for price stability. Over 100 years, the Fed has gone through periods where it is quite unpopular, even controversial. After the crash of 1929, the Fed contracted the money supply and raised interest rates, which exacerbated (or even caused) the Great Depression (depending on who you ask). Paul Volcker raised interest rates to extreme levels to break inflation in the late 1970s. He accomplished his mission, but he was one unpopular guy. Milton Friedman gave the Fed no love by equating the Fed’s dual mandate with an evasion of accountability.
The Fed has major control over money supply and has some regulatory responsibility over the banking industry, but its primary tool is to set the fed funds rate. The fed funds rate is an overnight rate used by banks when they borrow from each other. The Fed meets 8 times a year to decide whether to keep the rate the same, increase it (restrictive policy), or lower it (accommodative policy). Treasury bond yields trade independently of Fed policy, but generally, short-term Treasury yields will go up or down along with (or in anticipation of) changes in the fed funds rate.
The graph below shows the fed funds rate for the past 30 years. Since December, 2015, the Fed has undertaken 9 one-quarter % increases, bringing rates up to 2 ½% from a low of ¼%. These 9 Fed rate hikes, and especially the prospect for further rate hikes, are a big reason given for the ugly stock market during the fourth quarter.
Ben Bernanke was the Fed chairman during the Great Recession of 2008-09. After taking the fed funds rate close to 0%, and realizing his primary tool was used up, he discovered he had two new tools he could possibly use, though both were without precedent in the U.S. The first would be to continue to lower rates to negative levels, as Japan and the European Central Bank (ECB) have since done. However, Bernanke was concerned that long-term interest rates (set by the market) would not follow short rates down. Having control of long-term rates is the holy grail for Fed chairs; I remember Alan Greenspan once saying that if he could control long rates, he could control the economy.
Which brings us to the second tool Bernanke discovered: Quantitative Easing (QE). There is no consensus on who coined the phrase, but the Bank of Japan was the first to officially implement it. The Fed followed shortly thereafter, by starting to pay interest on excess reserves of the banks. Since loan demand was weak in the wake of the financial crisis, the banks parked several trillion “unused” dollars at the Fed, allowing the Fed to turn around and buy $4 trillion of long-term bonds with those deposits. This had the effect of taking a large chunk of bonds out of the market, which lowered long-term interest rates, which gave the economy a chance to recover. The economy has now recovered, so the Fed has started to unwind this program, by allowing $50 billion in bonds to mature per month. The chart below shows the Fed’s balance sheet. Assets have declined from $4.5 trillion to $4.1 trillion.
The Fed has never attempted the unwind of a QE program before, so the jury is out for what effect it will have on the economy. The effect of increasing the supply of bonds into the market should result in higher interest rates; in fact, they have hardly risen since the unwind began. Meantime, the Fed has done a very good job of controlling inflation and increasing employment, their dual mandates. Their main challenge now is to discern the neutral interest rate—not too accommodative, not too restrictive—and not go beyond it.
What is the neutral interest rate? That’s anyone’s guess to make. The market isclearly voicing an opinion today that it is lower than in past cycles. How do we know this? Because the 10-year treasury bond yield peaked this year at 3.25%, and now is 2.75%. Last cycle, in the mid-2000s, it traded up to 5%. In the late 1990s, it was 6%. Generally, the Fed doesn’t want to raise its fed funds rate above longer-term bond yields, because that’s called a yield curve inversion, and it precedes a recession with almost near certainty.
So, right now, the fed funds rate is 2 ¼% – 2 ½%. Since quoting a range is annoying, we just say the upper bound is 2 ½%. With one more hike, the upper bound would be 2.75%. That would be level with the current yields of treasury bonds that mature in 7-15 years. And it would exceed the 2.6% – 2.65% yields of bonds that mature in 1-5 years. That would indicate a flat-to-inverted yield curve. One more hike!
So why do Fed members plan to implement 3 more hikes?? This information is published in the minutes of every Fed meeting, and is the median of the predictions of all Fed members in its “dot-plot” survey. Clearly, the Fed and the bond market do not see eye-to-eye. Who’s right? It’s a question we grapple with every day. Back in the halcyon Greenspan days, the widely-used term was “Don’t bet against the Fed.” But if you have to choose between the Fed and the bond market, you should probably choose the bond market. At critical junctures in past cycles, when the yield curve inverted, the bond market told the Fed they had raised too many times, and the bond market was right. If you want more evidence, the Fed’s own dot plot has been consistently wrong since 2015. Fed members projected far more rate hikes than they actually implemented. The fed funds rate was supposed to be close to 4% by now, not 2.5%!
How this will all play out? The consensus is splintered into 3 groups. The worrywarts believe that the headstrong Jay Powell will ignore the bond market and keep raising rates toward the neutral rate of past cycles. The second group believes that Powell pays attention to the bond market, and will do anything to avoid an inversion. These “Fed doves” were emboldened in late November when Powell said the rate then (2 ¼%) was “just below neutral.” Now they are hopeful that he will pay attention to the bond market and stop hiking, stat. The final group of “Fed hawks” believes the economy is going to keep growing strongly, and inflation will rise, and thus the Fed needs to keep raising rates and the bond market is wrong. In their corner are a whole host of leading economic data which say the economy will continue to be strong next year and probably beyond, as well as data supporting the case that liquidity in the financial and banking systems is still ample (i.e. not restrictive). Plus, they might have history on their side. For the last 35 years (through 2016), inflation and interest rates have fallen, this after 35 years of rising inflation, from the late 1940s to 1982. Has inflation hit inflected again? This group could yet be proven right, but right now the bond market is scoffing at them.
Watching the yield curve has become a day job for many investors, especially folks who have been predicting a recession for way too long. As you can see from my final chart, recessions (shown by the green columns) do not start when interest rates are rising; they start when rates are already falling, especially short-term rates. The purple dotted line is short-term rates (90-day treasury yields), while the black line is 30-year treasury bond
yields. In past inversions, short rates clearly pass long rates…by contrast, today there is still 0.63% of daylight between those lines.
So has the Fed already made the dreaded “policy mistake,” or is it about to, or is not too late to pull back from the precipice? The stock market has been reflecting that concern throughout the 4th quarter, but fears were heightened by the Fed meeting on Dec 19. The selloff in stocks has been dramatically intensified by algorithmic trading, now responsible for 85% of market volume. Most technical indicators (including investor sentiment) reached levels that have historically marked bottoms in the stock market. The selloff has completely ignored the solid outlook for the economy (2-3% growth in 2019) and corporate profits (up mid-high single digits in 2019). The S&P 500 earnings yield minus the 10-year treasury bond yield, an indicator for the forward return potential of stocks vs. bonds, has rarely been higher. If a recession is not in the near future, stocks are attractively valued and should stage a rebound.
Written by David Meyer