Fed Delivers Warning To Investors

|
 |  Includes: SPY, TLT, XLK
by: Chris Ciovacco

Summary

A recent opinion piece may provide valuable insight into Fed policy.

Fed governors are not immune to outside pressure.

What to look for in this Wednesday's Fed statement.

The Federal Reserve is an interesting study in public relations. The Fed has twelve districts that release statements and publish studies. The Federal Reserve Board is comprised of seven members who often make public statements about monetary policy. The chair of the Federal Reserve Board also testifies and conducts Q&A sessions with the media. Often, statements coming from the various sources within the Fed seem to be highly contradictory and confusing, something that serves a purpose in the realm of monetary policy.

Fed Cares About Inflation Expectations

Experienced investors know central bankers care about their legacy, as most professionals do. While casual investors may believe all the Fed cares about is higher stock prices, the Fed is genuinely concerned about allowing inflation to get ahead of them. If inflation expectations begin to pick up, it can change habits, which ultimately can lead to real world inflation.

Fisher's Shot Across The Bow

On Sunday night, The Wall Street Journal published an opinion piece by Richard Fisher, president of the Federal Reserve Bank of Dallas. The text serves as a warning to complacent investors that the Fed cannot keep interest rates near zero indefinitely. The op-ed opens with a single sentence paragraph:

"I have grown increasingly concerned about the risks posed by current monetary policy."

That is a pretty strong opening statement meant to get the attention of investors and businesses impacted by interest rates.

Making The Same Mistakes?

If you were investing during the dot-com bubble, you remember the Fed failed to tighten margin requirements, which allowed speculation to run rampant. The Fed is often criticized for "keeping rates too low for too long" between 2003 and 2005. For example, the Federal Funds Rate was at 2.25% in January 2005. In the July 27, 2014 Wall Street Journal (WSJ) opinion piece, Fisher states:

"I believe we are at risk of doing what the Fed has too often done: overstaying our welcome by staying too loose, too long."

Incentives To Take On Risk

Fisher noted that Janet Yellen was also aware of the potential risks of maintaining the Fed's current stance. From Fisher's WSJ piece:

"In her recent lecture at the International Monetary Fund, Fed Chair Janet Yellen said, 'I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns.' She added that'[a]ccordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability.' I believe that time is fast approaching."

Investment Implications - Good To Be Aware Of

Should we sprint for the equity exits after reading Fisher's comments? No. However, it is good to be aware of the Fed's willingness to raise rates sooner than many market participants believe. The risk is not related exclusively to a rate increase. It is the timing of the rate increase that could catch some investors off guard.

How do we use all this? Fed policy is one of many inputs impacting the battle between bullish economic conviction and bearish economic conviction. As noted on July 28, the market will guide us if we are willing to listen. Not much has changed this week. Therefore, the 80% confident, 20% concerned analysis in this week's video still applies. Therefore, we continue to hold a mix of stocks (NYSPY), leading sectors (NYXLK), and a relatively small stake in bonds (NYTLT).

The possible market-spooking outcome this week or in the weeks ahead is if the Fed signals an interest rate hike may be coming sooner rather than later. Again, it is not the act of raising rates that matters, but the timing.

Disclosure: The author is long SPY, XLK, TLT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.