In “Narcos,” the Netflix show chronicling the rise and fall of Pablo Escobar, there is a gripping scene in the first episode that sets the stage for the entire series. When stopped at a bridge crossing by Colombian authorities, Escobar gives them a choice:
“Plata (Silver, take the bribe) o
Plomo (Lead, take the bullets)?”
They choose silver and appeasement, turning a blind to Escobar’s nefarious activities. In the short-run, everyone was happy: a potentially deadly confrontation was avoided and the easy-money profits of the cocaine trade were shared by all. But the joyful times did not last and the complicity of the authorities would come back to haunt them. They created a monster in Escobar and the drug trade would become impossible to control.
Over the past few years, financial markets have held the Fed hostage with a similar message. Armed with the knowledge that the Federal Reserve was openly targeting higher stock prices (via Bernanke’s “wealth effect” theory), the market delivered the following warning:
“Plata (Silver, keep rates at 0% and adding rounds of Quantitative Easing) o
Plomo (Lead, suffer a stock market decline and potential loss of your precious “wealth effect”)?”
In 2010, 2011 and 2012, when the Fed started talking about normalizing interest rates, the market made good on this warning: 17%, 21% and 11% corrections in the S&P 500 would follow. Each time, the Fed quickly reversed course, pleading “Plata, Plata, y más Plata” (see Stock Market Tail Wags Fed Dog).
In 2010, they initiated QE2 and promised to hold off on raising rates. In 2011, they initiated Operation Twist. In 2012, they initiated QE3 and promised to keep rates at 0% until the middle of 2015. And for a while, everyone was happy. The markets surged higher and the Fed was given credit for sticking with Mr. Zero Interest Rate Policy.
But in 2015, with QE3 over the Fed once again talking about raising rates, the market became volatile again. A 13% decline ensued which saw the VIX Index briefly spike above 50. The volatility didn’t fully subside until the Fed pleaded “no Más,” holding off on a September rate hike. We learned once more that the Fed’s “data dependent” process is code for “stock market and volatility dependent.”
Markets rejoiced thereafter. Rate hike expectations were pushed all the way back to April of 2016 and the S&P 500 rallied over 12% from its lows in 2013-14 vertical fashion. Then the October payroll report came in showing another month of job gains and decline in the unemployment rate to 5.0%. This was now a full 1.5% below their original rate hike threshold and below the levels at which the Fed hiked after the 1990-91 and 2001 recessions.
Apparently, it was too much good news. Market expectations quickly shifted back to a December rate hike and Jeff Gundlach came out saying a hike would “hurt the stock market.” The S&P 500 sold off around 5%. Now many are saying if the decline continues in the coming weeks the Fed won’t hike in December.
They are probably correct given the precedent but the more important issue is why they can’t seem to move a mere 25 basis points after seven years of 0%.
Is it really because the economy cannot handle it or is it because the Fed has become overly concerned about the short-term machinations of the stock market? I would argue the latter. And as the stock market has more than tripled since 2009 while the economy has grown at its slowest pace in history, perhaps it’s time to start focusing more on the economy.
I don’t pretend to know what the “perfect” level of short-term interest rates is, but I know it’s not 0%. We’re not talking about a move to 5%; we’re talking about a move to a range of 0.25% to 0.5%, which would still be extraordinarily accommodative.
Gundlach says the Fed can’t/won’t move in December. I’ll take the other side. They can move and they will move absent a complete market collapse. It’s time for the Fed to start showing some confidence in this economy again by moving interest rates from the crisis levels of December 2008.
Payrolls have expanded for a record 61 consecutive months. It’s high time the Fed start acting like something has changed over the last seven years, and changed for the better.
It’s also time to start acknowledging that there are unintended consequences of 0% and the longer the Fed waits, the worse the effect it will have on long-term economic growth. I have argued over the past year that 0% policy has actually become a headwind for growth as it: 1) is a tax on savings and therefore investing, 2) is leading to a gross misallocation of resources and capital, 3) is encouraging financial engineering (buybacks/mergers) over investments in capital/labor, 4) has already created the third financial bubble in the past fifteen years, 5) is putting less money into the hands of consumers, 6) is not helping real wages as asset price inflation (and rents) outpaces income gains, and 7) has only widened the wealth gap.
As for the argument that the Fed needs to keep rates at 0% to fight “deflation,” the data suggests that “deflation” is a myth. Excluding food and energy (the collapse in Crude has had an enormous effect here), prices are rising at close to 2% and have never dipped below 0%, even during the depths of the financial crisis.
But what about Plata o Plomo?
The Fed needs to send a clear message to the markets that they are no longer going to be pushed around by the easy money addicts wanting 0% rates forever. If the stock market goes down a few percent in the short-run as a result, so be it. It’s a small price to pay for improved long-term growth and stability in the economy.
But I would not be surprised if the opposite occurs, and the market actually rallies on a clear rate hike message from the Fed, putting an end to this endless period of uncertainty over when they’re going to move. The incessant delaying of normalization has became a source of instability in the markets.
As of this writing, the odds of a December rate hike stand at 68%. This is the highest probability of a hike for an upcoming meeting in over eight years. The market is saying a hike is coming. Let’s hope they’re right.
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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
CHARLIE BILELLO, CMT
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
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