- Current Fed Watching methods are dated, imprecise and often biased; this article introduces modern, unbiased quantitative Fed Watching data.
- Fed Watchers are typically "experts" expressing subjective opinions based on a single sentence or phase in a larger Fed communication. This qualitative material can't be incorporated into financial models.
- Increasing Fed transparency coupled with advances in modern textual analysis allow us to quantify the sentiment of Fed communications.
- The quantitative sentiment data presented here is comprehensive, unbiased and easily incorporated into financial models.
- Current data indicates the Fed sentiment continues to rise, despite concerns that winter weather slowed growth in recent months.
Fed watching has come a long way since the "briefcase watch" of the mid-1990s, but it is still based on subjective, imprecise interpretations of central bank communications. It is time for Fed watchers to adopt 21st Century methods.
The Briefcase Watch
Back in the 1990s reporters would follow around Fed Chairman Alan Greenspan trying to determine if his briefcase was thick (thus indicating a likely change in interest rates) or thin (indicating no change in rates). Since that time Fed watching has largely progressed thanks to advances in central bank transparency and increased number of communications, not better methods for interpreting Fed policies. Instead of relying on speculation about policy based on the thickness of the Chairman's briefcase, we now rely on "expert" Fed watchers speculating about policy (and market consequences) based on their personal interpretation of select fragments of information pulled from larger communications. This method is still subjective, qualitative and incomplete.
To supplement this imprecise methodology, investors have relied on the correlation between the Fed's main policy tool, the Fed Funds Rate, and bond rates to glean some quantitative information about Fed policy. Since the Fed Funds Rate has been pegged to the zero-bound for over 5 years, that tool has been of little use and Fed watchers have been forced to examine the Fed's "Quantitative Easing" program for concrete, quantitative guidance about the direction of Fed policy. With that program drawing to a close this year, Fed watchers will be left with only their inherently biased and simplistic method of interpreting Fed policy.
The common method of examining Fed policy has been for investors to rely on "expert" Fed watchers who prognosticate about likely Fed policy changes by splicing individual paragraphs, sentences, phases or even singular words. Investors assume these "experts" are correct based on some inside knowledge they have about the Fed, monetary policy or the broader state of the economy. These "expert" policy predictions are usually imprecise and often wrong.
Further complicating the role of "expert" Fed watchers is the confusing new Fed policy commonly known as "forward guidance." This policy has become increasingly prevalent over the last few years with Fed personnel referencing it 191 times between September of 2009 and the end of 2013. Nearly 70% of these references came since June of 2012 and more than a quarter of those occurring in the final 3 months of 2013.
With QE ending soon, even new Fed Chair Janet Yellen has acknowledged that the Fed will be "…using communication-mere words-as its primary monetary policy tool." Interpreting this new policy tool has been notoriously challenging for Fed watchers seeking to glean information about monetary policy timing and its impact on financial markets, as well as the broader economy. Simply, the modest predictive capacity of traditional Fed watching has been virtually nullified by evolving policies and abnormal economic conditions in recent years.
A new method of Fed watching is long overdue and increasingly necessary for market actors to glean vital information from the central bank. As with other facets of modern finance, the best way to approach this information asymmetry is through quantitative methods. Essentially, Fed communications must be systematically analyzed to concisely and precisely inform investors about upcoming policy changes and likely market reaction.
Thanks to advances in modern computing, textual analysis and machine learning technologies provide a path forward for systematically analyzing Fed communications. In particular, by analyzing the content of all Fed communications since 1998, my colleague and I have developed a means of measuring Fed sentiment toward the economy. This measure is called the Fed Playbook Sentiment Indicator (FPSI). The graph below provides the FPSI trend-line for 2013.
Fed Playbook Sentiment Indicator (2013)
As the 2013 FPSI data shows, although sentiment was steadily rising in September, when "expert" consensus was that the Fed would begin to taper their asset purchase program, sentiment levels were actually no higher than they had been a few months earlier in May when tapering was still believed to be several months off. Had investors had this information they could have predicted that interest rates would drop, equities would climb, the dollar would fall and commodity prices would level off.
When the situation repeated itself in December, sentiment had risen further, but was trending modestly downward immediately ahead of the FOMC meeting. This caused some "expert" Fed Watchers to doubt that tapering would begin before the new year. But again, looking at the FPSI in the longer-term context, it was clear that the sentiment of Fed officials about the state of the economy was markedly higher than in September, or at any other point in 2013. This indicated that Fed officials would likely be comfortable reducing asset purchases. However, the dip in sentiment ahead of the FOMC meeting led to the conclusion that those reductions in asset purchases would be very modest. Since that time, the general upward trend in sentiment has persisted and Fed policymakers have continued to modestly curtail Fed stimulus.
While raw Fed sentiment information is interesting to dedicated Fed Watchers, the real value of quantitative metrics like the FPSI are that they can be backtested against financial markets. Specifically, the FPSI correlates more tightly with long-term trends in bond markets than the Fed Funds Rate (FFR) does. While this makes perfect sense over the last 5 years with the FFR pegged to zero, it was also true during the housing bubble in the early and mid-2000s. In principle, this would have been valuable information to both investors looking to better understand bond market movements and to policymakers seeking to identify missteps in stimulative policies that risked fueling an asset bubble.
FPSI with FFR and 10YR
Even more striking than the correlation between the FPSI and bonds is the correlation between the FPSI and equities, particularly the S&P 500. As the graph below shows, since 2006 the FPSI and the S&P 500 have moved virtually in lock-step.
FPSI with S&P 500
These graphs also indicate that the FPSI may be a leading indicator across asset classes. This should come as no surprise since Fed officials have vast amounts of economic information at their disposal and their sentiment is influenced by that information. Further, it is no surprise that this sentiment leads financial market behavior since investors are typically reactive while central bankers are supposed to be proactive.
How to Use FPSI
Many readers are probably looking at this article and thinking that this makes sense, but how do I use this information to maximize my portfolio? There are a couple answers to that question:
- Professional portfolio managers can use this quantitative data by directly incorporating into your financial models. This eliminates the need to adjust the models based on qualitative Fed Watching material and it ensures that Fed sentiment is being incorporated into financial analysis in real time.
- Individual investors can capitalize on the FPSI as a leading indicator across asset classes. Specifically, the data indicate that although the FPSI is a strong predictor of upward trends, it is an even better indicator of downtrends. Therefore, individual investors can use this information to minimize downside risk by rebalancing their portfolio when FPSI shifts downward while a particular asset continues to rise.
Right now the FPSI continues to trend upward, but not as steeply as it did in late 2013. This coincides with the general Fed consensus that growth slowed in the winter months due to severe weather, but that the trend is still positive. This uptrend will likely continue to cause bond yields to rise and create modest strength in the value of the dollar. However, it is worth noting that the positive FPSI trend remains below the growth trend in equity markets. This is likely a result of QE dumping so much cash into the system that stocks are able to continue a bull run, but it is worth considering that although still trending upward, the FPSI is now indicating that equities may be over-valued and due for a correction.
Although economic uncertainty ensures that the FPSI is not a perfect instrument by which to analyze Fed policy, but it is far better than current qualitative methods that rely on "experts" cherry-picking individual sentences for analysis. Our patent pending quantitative methods are comprehensive, objective and historically verifiable.
The bottom line is that Federal Reserve policy has an enormous impact on global financial markets, but central bank communications have largely avoided systematic quantitative examination. Utilizing our proprietary content analysis methodology to examine monetary policy not only provides a comprehensive, unbiased examination of central bank communications, it also drags Fed watching into the 21st Century.
Note to Readers:
This is the first in a series of articles designed to introduce this new data. Future articles will assess how the Yellen Fed might behave differently than the Bernanke Fed and will showcase the forward projection capabilities of this FPSI data.
Additional disclosure: Along with my colleague, William MacMillan, I hold a pending patent on the methods for examining central bank communications that are discussed in this article. Further details about this data can be found on our website, FedPlaybook.com.