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The members of the most powerful financial body in the world (U.S. Federal Reserve Committee) are spending hours on end obsessing over two words: “considerable time.” I kid you not. You can read the minutes from the last FOMC meeting here for yourself. You’ll notice that the longest paragraph by far consists of a debate over whether to remove these two seemingly innocuous words from their official statement.
After keeping interest rates at 0% for an unprecedented six years, one would think that the Fed would be ready to stop saying that it intends to maintain rates at 0% for a “considerable time.” One would be wrong. You see, the Federal Reserve has built a stock market and financial system that has become increasingly dependent on the continuation of 0% interest rates. Any indication of a shift in this policy has made the markets very unhappy, thus requiring a quick dovish fix to satisfy the needs of the easy money addicts.
After a lengthy debate in the last meeting, the Fed members in favor of keeping the language in the statement won out, arguing that the:
“removal of the ‘considerable time’ phrase might be seen as signaling a significant shift in the stance of policy, potentially resulting in an unintended tightening of financial conditions.”
What did they mean by financial conditions and how would removing two words from a statement have such a negative effect? Perhaps they are they referring to the Chicago Fed National Financial Conditions Index which measures risk, liquidity and leverage. But that doesn’t make much sense, for instead of pointing to stress this index recently stood at its most benign level in history. How could they claim to be concerned about a tightening of financial conditions when financial conditions were about as loose as we have ever seen?
The truth is that by “financial conditions” the Fed is really just referring to the short-term machinations of the stock market. The Fed is afraid that removing the “considerable time” language might lead to a decline in stocks. Such a decline would be troubling to the Fed because it would jeopardize their “virtuous wealth effect” theory whereby higher stock prices are supposedly leading to more spending and higher incomes for all. If the basis for much of your easy monetary policy is this theory, then you cannot allow any decline in stocks because it will lead to an unwinding of the “wealth effect,” or a decline in spending, growth and income.
Let’s take a look back at recent history to see how the short-term movements in the stock market have become the key driver of monetary policy.
We’ll start with 2010. The economy was one year into its expansion and approaching the point where in every prior post-war cycle, the Federal Reserve would start discussing an imminent tightening of monetary policy. The first round of quantitative easing (QE1) had ended in March and the “financial crisis” was clearly over. In early April, the Fed Funds futures market was anticipating the Funds Rate would increase to over 1% by May 2011 and over 2% by early 2012. In its April statement, the Fed noted that “economic activity has continued to strengthen” and the “labor market is beginning to improve.”
What happened next? We saw the flash crash in May and a 17% decline in the S&P 500 to its low in July.
Fed officials responded to the stock declines by coming out with dovish statements and emphasizing the weakness in the economy. By early September, the Futures curve had shifted dramatically lower (see green line in chart below), with the market now expecting rates to remain below 1% as far out as August 2012. In its September statement, the Fed had a much bleaker view of the economy, saying that “output and employment growth had slowed in recent months.” Ben Bernanke began signaling that another round of quantitative easing was coming at Jackson Hole in August 2010 and QE2 was announced in November.
Stocks rocketed higher on the prospect of 0% rates for longer and the new round of asset purchases. The economy continued to expand and by April 2011 market participants were once again anticipating a tightening cycle to begin within the next year, with an expectation of the Fed Funds rate moving to over 1.5% by the end of 2012. In its March statement, the Fed said the “economic recovery is on firmer footing, and overall conditions in the labor market appear to be improving gradually.” The Fed ended QE2 in June 2011.
What happened next? Stocks peaked in early May and would decline 21% to their low in early October, with the most precipitous fall occurring in August.
Fed officials responded to the August decline with dovish talk almost immediately, culminating in Bernanke’s Jackson Hole speech where he alluded to Operation Twist and emphasized the weakness in the economy and labor market. Twist would be announced in late September and by early October the Fed Funds Futures had completed shifted. The market (green line below) was now expecting rates to stay below 1% as far out as September 2014. In its September statement, the Fed now stated that “economic growth remains slow” and pointed to “continued weakness in overall labor market conditions.”
On this commitment to easy money, stocks pushed higher once again into the end of 2011 and early 2012. By April 2012, the Fed was more optimistic, saying in its statement the economy had been “expanding moderately” and “labor market conditions have improved.” Market participants were now expecting a move to over 1% by early 2015.
What happened next? The market peaked in early April 2012 and suffered an 11% correction until its low in June.
Dovish commentary from Fed members ensued in response to this decline, with Twist being extended in June. By early July expectations for the first rate hike had been pushed out until the middle of 2015, nearly three years into the future.
Rumors of additional stimulus continued throughout July and August, culminating with Bernanke’s Jackson Hole speech in late August 2012 where he alluded to QE3. In its August statement, the Fed said “economic activity decelerated’ and “growth in employment has been slow,” providing the cover necessary for additional easing.
In early September, QE3 was announced and the Fed added that “exceptionally low levels” for the federal funds rate were “likely to be warranted at least through mid-2015.”
Stocks raced higher in early 2013, celebrating open-ended QE and the prospect of 0% interest rates for at least another two years. The advance was nearly vertical up until late May, when Bernanke suggested the Fed might begin to “taper” its purchases. The market reacted violently in what became known as the “taper tantrum,” with everything from bonds to stocks to gold selling off in dramatic fashion.
You can see how the Fund futures curve shifted after Bernanke’s “taper talk,” with expectations for future rate hikes being pushed forward (green line).
In late June, near the end of the stock decline, Bernanke reassured market participants that a reduction in purchases was not imminent and that rates would continue to stay low for a long time regardless of any tapering. The market quickly rebounded as expectations for the first rate hike were pushed out once more and the S&P 500 went on to have its best year since 1997.
In December 2013, a slow tapering of asset purchases was finally announced, with a firm commitment to 0% interest rates as long as the unemployment rate remained above 6.5%. The equity market sold off in January 2014 with the start of the tapering but quickly recovered. In March, the Fed was forced to drop its 6.5% hurdle as the unemployment rate was quickly approaching this level. The new Fed language was that the Funds Rate would stay at 0% for a “considerable time after the asset purchase program ends.”
The large cap indices surged higher on this dovish news and were trading well into early September. The small cap indices, however, were beginning to struggle mightily, diverging from their large cap peers. We were approaching the end of QE3 and market participants were clearly getting nervous, rotating out of more illiquid small and micro-cap positions in favor of more liquid large caps. In early September, the futures market was expecting the first rate hike to begin around the middle of 2015.
Then October came and with it we saw the worst decline in stocks since 2012, a 9% drop in the S&P 500 through the middle of October which briefly brought the index into negative territory on the year. Expectations on the Fed Funds rate were already shifting out by this point (green line).
A decline of this magnitude was simply unacceptable and a number of Fed officials expressed growth concerns in Europe and other dovish-leaning statements on the way down to 9%. But it was not enough and the market continued to fall. James Bullard (St. Louis Fed President) would finally offer the desired medicine on October 16th, the day of the low, saying that “if the market [is] right and it’s portending something more serious for the U.S. economy, then the committee would have the option of ramping up QE at that point.”
The comments from Bullard were extremely important, and reinforced the reality that when the Fed talks of being “data dependent” they are principally referring to short-term stock market data. A v-shaped rally ensued after these comments, and was bolstered by the release of the FOMC statement in October in which the Fed elected to keep its “considerable time” language even though QE3 was ending.
Which brings us to today. It has been a month since the end of QE3 and the attention has shifted to the first rate hike. Everyone’s focus for next week’s Fed meeting : will they keep “considerable time?”
Of course it is impossible to predict such a thing but that won’t stop people from trying. Why is the market so obsessed with these two words? Is this rational behavior? I used to think the obsession was crazy, but now I suppose it is somewhat sane, because if everything is predicated on keeping interest rates at 0% than any shift in that policy is all that matters.
Simply, the market is obsessed with it because the Fed is obsessed with it. In saying that QE and 0% policy is designed in large part to boost stock prices, the Fed has elevated their importance to unprecedented levels. When they said in the recent minutes that removing the “considerable time” language would hurt “financial conditions,” they are telling you how unstable the house of cards that they have built really is.
If one were to look at it objectively, there would be no way you would come to the conclusion that 0% policy should remain for a “considerable time.” We are more than five years into the expansion, non-farm payrolls have grown for a record 50 consecutive months, and the unemployment rate is down to 5.8%.
But again, this is not the “data” the Fed is referring to when it says it is “data dependent.” If it were, a rate hike would have occurred a long time ago. Economic growth (real GDP) has been remarkably stable over the past few years and the unemployment rate has steadily declined (see charts below), but Fed policy has shifted time and time again when the stock market has corrected as illustrated above.
All of this may be interesting, you say, but you still desperately want to know when the Fed is going to raise rates. Well, the futures market is currently expecting the first rate hike to occur in July 2015. At that point it will be six and a half years of 0% rates. But as we know, whether that rate hike actually occurs in July is dependent entirely on the direction of stocks between now and then. If there is an uninterrupted rise higher, they may very well raise rates and if the rise is parabolic perhaps they’ll consider raising earlier than July.
But as we have seen over the past few years, if there is any stock market weakness between now and then the playbook is as follow: dovish statements, followed by pushing out expectations, followed by another round of QE if the stock decline is large enough.
In short, the stock market tail wags the Fed dog. Is this a good idea, letting short-term stock market movements dictate monetary policy? Only if you believe, as the Fed does, that the stock market is the economy and that creating another stock market bubble will lead to higher real growth and prosperity for all. If you believe otherwise, or that higher short-term rates might actually be helpful for the economy and real wages at this point, then what the Fed is doing is counterproductive and simply diverting our attention from addressing the important structural issues that are actually impeding growth.
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 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 two award-winning research papers in 2014 on Intermarket Analysis 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, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
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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