“Will they, won’t they” the question that raged all week across the financial blogosphere as investors, speculators and the tin foil hat wearing crowd debated whether the FOMC could perform the first rate hike in nearly nine years as early as this June. While investors reacted positively to Janet Yellen’s testimony before the Senate on Tuesday, giving the S&P 500 it’s only positive day for the week and pushing the iShares Treasury Bond 20+Year Fund (TLT) up nearly 1.31%, the mood shifted with the changing tone of the economic data released this week as the market tried to digest what the end of the Fed’s “patience” might bring. With every other financial professional throwing their hat in the ring, it’s time for the Yinzer Analyst to get off his duff and explain to you why the Fed will be raising rates and how you can prepare your portfolio for when it happens.
I’ve talked at length about the Federal Reserve and why it might choose to raise rates now, the impact that it might have on the market and while standing by what I’ve said already, I think it’s to add a new dimension to our thinking. So much of the conversation about the first rate hike in nearly a decade is about whether or not it’s premature, overdue or whether Chairwoman Yellen is just playing chicken with the market to push risk premiums higher. While you can find almost any evidence to support any of those arguments, take it from my years of experience as a portfolio manager that playing those logic games when it comes to the Fed is simply setting yourself up for failure. Plenty of far better money managers that I tried to predict what the Fed was going to do between 2008-2014 and lost WAY more money than they could afford to in the process.
(The Yinzer Analyst thinks this week’s bounce in TLT has more to do with hitting prior resistance than any fundamental case for lower bond yields being made)
The worst part of all was that their mistake was simple; they weren’t just trying to predict the likely course of the Fed and the timing of a rate hike, which is a herculean task in itself (and success largely comes down to luck when you start involving two potential outcomes and a diverse board like the FOMC) but whether explicitly stated or not, their analysis was always tainted by the thought “The Fed SHOULD do this.” With their minds clouded by the belief that they alone knew the correct course of action, they let their opinions on the proper course for the Fed influence their decision making and the rest can write itself. Ben Bernanke one more than one occasion talked about the power of QE to support asset prices and create a wealth effect that would push the market higher and raise investment (more here at the Big Picture.com) He was telling you exactly what was going to happen because he WANTED it to happen and telling the market was the best way to bring that about. Think of it as a self-fulfilling prophecy that many in the market largely ignored.
So what should an honest investor due in a situation like this? First, focus on what the Fed is telling you and look at the same charts they are. Yes, it takes a doctorate in dissimulation to make sense of their minutes and prepared statements, but once you learn to read the signs, the road they’ve been laying out for years is easy to follow. Once you’ve done that, you can start preparing your portfolio for the shape of things to come.
So if the FOMC going to raise the Fed Funds rate in 2015? Yes, they have literally been telling the market for years that they wanted to end what they consider to be extremely accommodative monetary policies and getting off the zero bound is the final step. Everything that’s come out of the Fed recently from Janet Yellen or Stanley Fischer has been reinforcing that hikes are coming in 2015 no matter what the Fed Fund futures are indicating. Remember, they never wanted rates to stay this low for this long and in their minds, the Fed was forced into this. After the politics around the American Recovery and Reinvestment Act of 2009, the national debate shifted from supporting economic stability by maintaining spending to keeping the debt/GDP level tied to a useless target derived from now discredited research. As government spending dropped and actively subtracted from economic growth for years, the focus shifted to loose monetary policy to keep personal consumption expenditures and investment from collapsing. By and large, they’ve succeed; in fact, they are well past the point when they would have raised rates in prior downturns.
Let’s look at a few charts and starting with the headline employment report, during the last two recessions, the Fed Funds rate began to rise around the time that the year over year percentage change in total employment turned positive. No one would argue that the Great Recession was different; employment fell much more drastically than in previous recessions and the average length individuals were unemployed skyrocketed, but from the point of view of the FOMC members, employment growth has been strong and sustained with many members arguing that QE3 was largely pointless and that rates should have risen long before now.
A similar story can be told with real personal consumption expenditures which even in the lowered GDP revision released on Friday are now growing at their fastest rate in years and contributed nearly all of growth in economic output in 2014. Again, the Great Recession saw the largest sustained drop in real PCE since the 70’s and while the growth has stabilized at a lower level seen in prior recoveries, it has gone on for a much-longer period without a rate hike than in other cycles.
You could also look at the growth in commercial and industrial loans; typically rates begin to rise when the year-over-year change in loan growth becomes positive. Like unemployment and real PCE, the Great Recession was far worse than prior ones, but the time has long since passed when rates would begin to rise.
And what about the counter argument that low-inflation means the Fed should commit to keeping rates low (like zeroish) until they have finally broken above the 2% range. We’ve talked about this in prior posts but there are two points against this argument; first is that while many investors may think of inflation as historically running at 3% or 4%, using core CPI to strip out the highly volatile energy component has run far below those levels and in fact has been close to or at the more recent rates for some time. I don’t want to get into some Shadow Stats argument, so just take a look at this chart of the Fed funds rate and core CPI then look at the two solid lines. The first is the average year-over-year change in core CPI for the last ten years, the second is for the twenty year period. Over the last ten years core CPI has been at 1.9% and only slightly higher at 2.1% for the last twenty. You can see we’ve already touched the ten year average in this recovery without sparking a rate hike, something that has driven the hawks on the FOMC mad.
The second argument comes from Stanley Fischer who on Friday noted that the recent rise in economic activity is directly attributable to the FOMC’s policies and that impact is now being felt is only in its early stages. Remember that the Fed is a backwards looking agency; their divination’s for the future rely on recently collected data that is matched to historical patterns for interpretation. Yes, that maybe oversimplifying the situation (and making it somewhat akin to augury) but it’s the truth. The Fed has been terrified of letting inflation creep too high because once the cycle starts, they might not be able to stop it without drastically overshooting the target.
Remember when QE3 was first proposed and then Chairman Bernanke said he was determined to get inflation to 2% or above? Well he lied; neither he or Yellen is at all comfortable with the idea of inflation getting to 2% or above and essentially started talking the market down from its QE3 highs as soon as inflation expectations got anywhere close to 2%. They why comes to down to something we’ve already talked about before; the idea that rising rates will actually increase the velocity of money, raising potential GDP and potentially adding even more inflation to the economy. You can read more about it in a previous post here, but the idea is well documented and with the end of QE3, M2 velocity has begun to stabilize while even the modest rate hike forecasts could be enough to encourage more investors to drawn down their liquid positions and invest the capital.
The final reason (and most important )why the Fed will raise rates is something we’ve talked about extensively here at the Yinzer Analyst, but the Fed is terrified about not just being on the zero bound and having no room to maneuver if the economy weakens but that they’ve deliberately altered how risk is perceived in the market. Let’s start with a few charts:
Investors are willing to commit to 10 year Treasuries for a rate slightly above that of core inflation over the last 10 years. On a 30 year basis they’re willing to lock in a potential risk premium of something like .7%, not exactly confidence inspiring is it? If investors are willing to commit to rates like that, what does it say about the growth outlook in America going forward? Even with the recent collapse in energy prices, is it at all likely that deflation will take hold here at home?
But more importantly, the Fed’s actions have had a major impact on the equity risk premium as well. You can approach it either mathematically where a “risk-free” rate is a vital component of every calculation and in every model used to determine the rate of return for equities. With risk-free rates that were low (or negative) as up until recently, you could justify incredibly high valuations; a situation that has already been slowly unwinding as investors begin to perceive the regime change in the market.
The second way to look at is something we’ve talked about extensively here, most recently on December 14th, the idea that the Federal Reserve has been the prime mover that has kept this market barreling higher. Remember these charts we showed that demonstrated how the major moves in the market coincide with the Fed’s QE programs?
Do you think it’s another coincidence that the market has gone essentially no-where since the end of QE3? While the S&P 500 continued to advance in 2014, it was a highly volatile year compared to 2013 and until the famous Evans rally in mid-October the year was setting up to be a push. With QE3 officially over and the prospect for rate hikes on the table, it’s no wonder the S&P 500 is consolidating while capital continues to flow into European equities at a tremendous rate; capital is going to where monetary conditions are the easiest and escaping where they’re the most uncertain.
So what does a rising rate environment mean for equities going forward and what can your portfolio do about it? Check in for your next few posts on protecting your portfolio and the importance of knowing your risk free rate.