The Fed Already Tightened 3.25% And Probably Doesn't Know It

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Includes: DIA, QQQ, SPY
by: Macro Ops

Summary

As seen in the Shadow Federal Funds Rate, the effective interest rate was as low as -3% in April of 2014 before the Fed started tightening.

The current rate of 0.25% means the Fed has already tightened by 3.25%.

There is no way the Fed will stick to its proposed rate hike schedule. If it does, we should expect crippling deflation, a market crash, and a resulting depression.

FED "Don't Fight The Fed" is a Wall St. adage as old as the Central Bank itself. The reason for its staying power is that it's absolutely true. Interest rates set by the Fed are one of the single most important factors affecting stocks and the wider economy.

The Fed Funds Rate affects the interest you pay on a car loan, the demand for housing, the hurdle rate for a company to make capital expenditures, the discount rate used to value companies and their stock, and much more.

This is why there's always so much hoopla over what the Fed is going to do…. they have the biggest lever to turn the business cycle.

When the Fed announced they were hiking rates in December, a lot of talking heads came out saying investors shouldn't be worried. They said that historically, equities don't negatively react until at least the third rate hike or so.

In this, they are right. There is a certain lag time between when rates are first raised to when equities start selling off due to tightening monetary conditions.

But what these commentators fail to grasp is the loosening/tightening effects of quantitative easing (QE). With the Fed Funds Rate already at the zero bound, the Fed was forced to buy treasuries through QE to push the yield curve lower, effectively loosening monetary policy even more.

Quick aside on how QE lowers interest rates: The Fed creates money and buys securities (ie, government bonds, mbs etc) from banks. The banks take that money and buy new securities to replace the ones they sold to the Fed. This creates a lot of demand, primarily for government bonds, because banks have to hold a certain amount "safe" assets on their balance sheets. This demand for bonds pulls interest rates lower.

The Fed transmits interest rate policy through the short end with the Fed Funds Rate. QE helps pull down longer duration rates, but when rates are already near 0, the cost of money can essentially go negative (as we'll see below).

The Fed does this with hopes that lowering rates will push investors further out on the risk curve and inflate asset prices (ie, equities, home prices, bonds). And with inflated asset prices, people will feel wealthier, and a positive "wealth effect" will be created, driving people to spend more.

The Fed got part of their desired effect with a large runaway bull market as investors took on riskier investments in search of returns. But it's probably safe to say the economic wealth effect the Fed believed would occur never truly materialized.

The reason the market has been selling off so soon after the first rate increase is because when adjusted for the conclusion of QE, the Fed actually started tightening in October 2014… and has already tightened 3.25%.

We can see this tightening in the Shadow Federal Funds Rate - a nifty model built by economists at the Atlanta Fed which can be found here - that accounts for the loosening/tightening effects of QE at the zero bound of rates.

Click to enlarge

As you can see in the chart above, the effective rate was as low as -3% in April of 2014. It began rising in October 2014 when the Fed ended their bond buying program (QE).

Combine the end of QE with the recent 25bps December rate increase and you have a Fed that began tightening nearly six months ago. And their total rate raise actually comes to 325bps. That is a lot… which is why we're seeing so much market volatility.

This is also why the market doesn't believe the Fed is going to hike four more times this year and then again in 2017. There is absolutely no way. Neither the market nor the economy could handle eight more hikes. Assuming an increase of just 25bps each time, that would be an additional 2% over the next two years, bringing the effective tightening to 5.25%. That would be one of the most aggressive tightening cycles in US history.

Our team at Foundation believes that the Fed may be able to hike another 25bps in March. And that's a big maybe. After that it's likely we'll get QE4 before another increase. Of course, more easing won't come until further substantial market pain.

The chart below is another example of how little the Fed understands about the dynamics of its own monetary tools. It shows the high-yield spread at the start of past hiking cycles. As we can see, current junk yields are substantially higher than at the beginning of any past hiking cycle - which is due to the effects of QE.

Click to enlarge

Generally, the Fed hikes rates when an economy is running too hot. The goal is to stifle the rise of inflation. But this time, the Fed is beginning its conventional hiking cycle when inflation is not a concern. It's also a time when the economy is turning from lukewarm to cold.

If the Fed remains dead set on hiking rates further despite the reactions of the market and the economy, then we should expect crippling deflation… a market crash… and a resulting depression.

We have high confidence that there's further trouble ahead for markets, regardless of what the Fed does. But the degree of trouble is very much dependent on what the "Masters" of monetary policy decide to do with the cost of money. Hopefully they will figure out that they've already tightened over 3%....

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.