An old Wall Street saying opines that one shouldn’t “fight the Fed” and it is said to be good advice. The popular belief about this saying is that it means one should embrace risk when the Fed is easing because ultimately the goal of the easing (more growth) will be accomplished. When the Fed is tightening one should shun risk, assuming that the goal of the tightening will be accomplished as well. I guess when the Fed is just talking one is reduced to coin flipping. The problem with this hoary old chestnut is that it is pretty lousy advice. It turns out the Fed isn’t nearly as powerful as the old saying implies. Yes, ultimately the economy will turn higher after a slump but whether that is because of the Fed or in spite of them is a bit murkier.
Anyone adhering to the don’t fight the Fed admonition in early 2001 would have walked right into a recession and a near halving of their equity portfolio. It didn’t matter that the Fed was easing. We still got a recession and a bear market. A similar outcome awaited the believing soul who stayed the course with stocks in late 2007. The Fed was cutting like mad and it turned out that it didn’t matter one iota. The Great Recession still arrived and a bear market still mauled stocks by 50%. Now to be fair there have been times when not fighting the Fed has been the right thing to do. One example is 1998 when the Fed cut the Funds rate three times during the Asian crisis. We didn’t have a recession and stocks went on to scale the heights of the dot com mania.
So, it seems that fighting the Fed or not maybe isn’t the proper way to look at this. It seems more accurate to say that one should pick one’s battles with the Fed very carefully. More importantly, consider Fed policy within the context of other market based signals. Given a choice between following a market based indicator and the rantings of the Fed chair, go with the market. It won’t be right every time but it is the wisdom of crowds and a much better bet than anyone down at the Fed. And when the market signals conflict with the Fed’s outlook, pay attention because the Fed will probably eventually have to come around to the market’s way of seeing things.
I bring this up because as in the cases mentioned above, the Fed today isn’t dictating to the market but rather the other way around. For the Fed does not lead, it follows. It follows the market because frankly it can’t be any other way. The Fed is not now nor has it ever been sufficiently powerful to overcome the market and force it to bend to its will. And last week we got more evidence that despite decades of practice, years of trial and error, the torturing of mounds of data with ever more powerful processors, the Fed still hasn’t mastered this forecasting game any better than the aggregated opinion of millions of traders and investors embodied in what we call “the market”.
After the FOMC meeting last week, the Fed released its new “dot plot”, its guesses about interest rates, growth, inflation and unemployment for the next few years. As has been the case every year in memory, the Fed had to move its dots lower to match what the market was already predicting. 2015 real GDP growth expectations were reduced to 1.8 to 2.0% from 2.3 to 2.7% growth. The unemployment rate was reckoned by members to be a bit higher than previously forecast and rather than two, the Fed now expects to hike rates only once this year. In other words, the Fed changed its forecasts to move closer to what the market was already predicting, to acknowledge the reality of the current economic situation. A look at the Fed Funds market reveals that a rate hike in September carries odds of less than 1 in 5 while December is a coin flip. Those are not appreciably different than what prevailed prior to the Fed’s unveiling of its latest prognostications.
The market generally does a pretty good job of predicting future growth and inflation. The nominal Treasury and TIPS markets don’t have any political axes to grind or preconceived notions about the effectiveness of a particular economic policy. The high yield bond market does not care who occupies the Chair at the Fed. Markets just provide the real time expectations of the crowd and it is those expectations that matter for investors, not your own and certainly not the Fed’s. What we’ve seen over the last few months from those markets was reflected in what the Fed did with its dots last week.
Real growth expectations haven’t really moved much since the beginning of the year, with TIPS yields oscillating in a small range. Inflation expectations, on the contrary, have been rising as reflected in the difference between nominal bond and TIPS yields. At the 10 year maturity, inflation expectations are now about 1.9% which you might recognize as being quite close to the Fed’s target of 2%. Unfortunately, real growth expectations are a lot less than that if one assumes the nominal 10 year Treasury is a good proxy for nominal growth expectations (and there are good reasons to do so). Yes, you did that math right. The market is predicting real growth of less than 0.4%/year over the next 10 years.
The yield curve also provides useful information. The yield curve, despite fears of a Fed tightening, has been steepening since early this year. That is just a confirmation in many ways of what the TIPS market is telling us, mainly that nominal growth expectations are rising and most of that is due to a change in inflation expectations. The short end of the curve has barely budged this year, an acknowledgement that the Fed isn’t hiking anytime soon while long rates have moved higher to reflect the fear of inflation. Further bolstering the inflation fear evident in the bond markets is the US Dollar index which peaked in mid-March. As the dollar has fallen the yield curve has steepened. It is a remarkably consistent message from the market. Real growth expectations are falling, inflation expectations are rising, a kind of mini stagflation.
Moving over to the credit markets, we find that spreads are once again moving wider. Interestingly, it is not just the junkiest junk where spreads are widening. Indeed, spreads are widening across the credit rating spectrum all the way up to AAA credits which have recently moved wider by about 20 basis points. Not much obviously and probably nothing to be concerned about but interesting nonetheless. For those who thought the widening of spreads was all about the shale industry, I think this should be a warning that the market is getting concerned about more than just a few junky oil companies.
And so, it appears as if the Fed may have gotten itself into a bit of a pickle. Inflation expectations at the 10 year maturity are almost exactly on their target but real growth expectations are way below what would be acceptable. The Fed wants to hike rates but doing so will probably pull down not only inflation expectations but also real growth expectations. If they leave rates at zero and inflation expectations continue to rise, the bond market will do their tightening for them, at least at the long end of the curve. As I said, the Fed follows where the market leads.
Other interesting nuggets can be gleaned from the market. The fact that the US dollar peaked in mid-March would seem to indicate that growth expectations are equalizing between the US and the rest of the world. Since US real growth expectations haven’t changed much, this would seem to be more about what is going on in the rest of the world than what is going on here. Since the dollar index is heavily weighted to the Euro and Yen, growth expectations for those areas are rising relative to the US (probably more about Europe than Japan). Given that the dollar has been fairly stable against gold since mid-March and that EM currencies have also rallied some, expectations for the rest of the world would seem to be stable to rising as well.
And that is where we stand whether the Fed likes it or not. Real growth expectations are flat to falling. Inflation expectations are rising. Capital is flowing away from the US and back to international markets and economies. Credit markets are starting to get worried. What we don’t know is whether these trends are durable, whether they will last long enough for a long term investor to take advantage of. I happen to think they are but I must admit it isn’t a slam dunk case for sure. Europe does not appear to have changed any economic policy sufficiently to affect their long term growth arc. Japan is improving but only slowly. Most people seem to think that China has a stock market bubble that will end badly. Of course, that would be the same people who warned us that the bursting of their housing bubble would be the big bang and that so far has been a big disappointment in the financial crisis department. Australia, Canada and most of Latin America are dependent on China.
But despite those fears – some real, some probably imagined – it seems best to trust what the market is saying. So, forget the Fed. Don’t fight the market.
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