The Federal Reserve policy is fairly easy to predict, yet many strategists along with the market continue to get it wrong. The reason why market participants get their predictions wrong is because they equate what the Fed should do with what it will do. When you take the objective look at QE and realize it boosted asset prices without growing the economy, you recognize the Fed has not acted rationally. When I make my predictions, I assume the Fed will do the wrong thing because that's what it has been doing for years. I explained in my last article how the Fed's policies have only created bubbles in junk bonds and stocks instead of creating real growth.
The Fed Is Dovish: Read The Entire Statement
You can look at my comment on this article below at the beginning of the year. I have predicted the Fed to cut rates once this year while many were calling for four rate hikes. Even if the Fed raises rates once in December, my estimate will be closer than what most were calling for. The simple question you need to ask is "why would the Fed raise rates now, when the economy was stronger in the past?" The chart below shows the economy is at one of the weakest periods since the financial crisis, so moving now makes little sense. The Fed had the opportunity to raise rates throughout this weak recovery, but never has other than the one quarter point hike in December.
While the Fed has been posturing through forward guidance this entire year that it was going to raise rates, this has been all talk and no action. Instead of only focusing on whether the Fed will raise or cut rates, investors should take into account everything it states in the presentations to form logical conclusions. Even though I have stated the market has predicted the Fed's actions incorrectly, let me clarify that point. The CME Group gauge which shows where the market thinks rates will go has consistently overestimated the chances of a rate hike. As you can see below, on January 6th the gauge was expecting a 52% chance of a rate hike in March. Ten months later, we still haven't gotten one. While this gauge has been wrong, the market has been a better predictor.
The market rallied after Yellen suggested the Fed may buy stocks (NYSEARCA:SPY) or corporate bonds (NYSEARCA:LQD) in the future. She stated at Jackson Hole "In addition, policymakers inside and outside the Fed may wish at some point to consider additional options to secure a strong and resilient economy." The additional options are buying stocks and corporate bonds. Yellen stated at her testimony before the House Financial Services Committee "If we found, I think as other countries did, that they could reach the limits in terms of purchasing safe assets like longer-term government bonds, it could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions." This is more dovish language. These statements have caused stocks to rally. The market correctly understands that the Fed raising rates a quarter point is meaningless when you take into account the fact that it may actually buy stocks further down the line.
I consider the Fed buying corporate bonds and stocks to be part of its forward guidance at this point. We know the Fed spends hours on properly articulating every sentence correctly in its statements. This implies Yellen also purposely talks about the possibility of buying stocks to effect the market, just as she talks about rate hikes to affect the market. Talking about buying stock softens the blow of rate hikes. However, I think the Fed wouldn't want to raise rates at all if it thinks this would cause it to have to buy stocks in the future to stave off a recession. This is why I urge investors to read the entire statement to get an overall feel of the Fed's posturing, instead of only looking at the possibility of a rate hike.
Fed Ignores Inflation
Moving on to Yellen's most recent statements, in a Boston Fed speech she said "to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market." To translate this statement in layman's terms, she is saying if inflation rises above the Fed's 2% target, the Fed will still keep rates low. This is convenient because core inflation has been rising to near the highest rate since the financial crisis. At this point, the Fed has decided to ignore its mandate for stable prices in order to keep the bubble economy going.
The Fed is in a situation where a rate hike could spur the recession it is trying to prevent. However, if it doesn't raise rates it won't be able to cut them when the next recession occurs. Therefore, the Fed had decided to talk tough on rate hikes, do nothing and then mention it may be able to buy stocks and corporate bonds if the economy deteriorates. It now is willing to ignore inflation to maintain this balance in policy.
Yellen Ignores Weak Labor Market & Aggregate Demand
Keep in mind the labor market is not strong like Yellen suggests. As you can see from the chart below, the Fed's labor conditions index has been negative almost the entire year. Yellen is suggesting she can let the economy maintain its strength and allow the labor market to continue adding jobs because of slack in the labor market. However, the labor market is weakening even without a rate hike, so the Fed isn't raising rates because if it did the labor market may get even worse.
Yellen also suggests demand is getting stronger, but the Fed can let the pressure get stronger. This is ignoring the recent consumer expectations which fell 7.4% month-over-month and shows signs of peaking as you can see in the chart below. The Fed isn't keeping rates low and letting the economy get stronger than normal cycles; it needs to keep rates this low because the aggregate demand is weakening. It missed the opportunity to raise rates a few years ago when the economy was stronger.
Fiscal Stimulus & Fed Buying Stocks? Not So Fast
Now I will go over where the market is wrong with regards to how monetary and fiscal policy will play out over the next 12 months. As I said, the Fed buying stocks and corporate bonds is now in its forward guidance. While this is the case, Janet Yellen does acknowledge this is in the hands of Congress when she says "Well, the Federal Reserve is not permitted to purchase equities. We can only purchase U.S. treasuries and agency securities. I did mention in a speech in Jackson Hole, though, where I discussed longer term issues and difficulties we could have in providing adequate monetary policy. Accommodation may be somewhere in the future, down the line that this is the kind of thing that Congress might consider, but if you were to do so, it's not something that the Federal Reserve is asking for."
There are two clauses to her statement about the Fed buying stocks. The first point she makes is that the Fed is not asking for Congress' permission. The logical question to follow up on is "what will make the Fed ask for permission?" The only way the Fed would ask for permission is if the economy weakened further and stocks were crashing. That's what equity bulls have to understand. The Fed will only buy stocks if stocks fall, so buying stocks in anticipation of stocks being bought by the Fed ignores the first step in the equation.
The second step is getting Congress' approval. Remembering the 2008 financial crisis, Congress only passed TARP when the economy was on the brink. Whether TARP saved the economy or made it worse is a conversation for another day, but the point here is Congress won't immediately grant the Fed the ability to buy stocks unless there is a crisis. Given that the GOP will likely still control the House of Representatives over the next 2 years, the odds get longer that this would ever get passed by Congress.
With regards to the presidential election, if Trump wins the Fed will not buy equities. If Hillary wins, we go through the two clauses I explained above. This means if Hillary wins, the odds of the Fed asking for and being granted access to buy equities seem unlikely. Like I said, the market should initially rally on the Fed hinting at this possibility, but the reason the market doesn't jump even higher is because it knows the chances aren't likely. In the longer term, I think the bulls aren't taking into account the initial fall which will have to occur before any major monetary policy easing happens.
This same logic goes along with fiscal stimulus in 2017. The market is pricing in a stimulus in 2017, but I don't see anything happening unless the economy gets worse and stocks fall. It is simply impossible for Hillary Clinton to go from running for president on the point that the economy is strong, and then immediately call for a fiscal spending spree because the economy needs a boost. In a similar manner, the Fed is claiming the economy is strong, so it can't take extraordinary actions unless the market crashes.
Another point which needs to be considered is the government's deficit since a fiscal stimulus would add to it. In 2016, the deficit is expected to rise for the first time since 2011. It is expected to increase 34% to $587 billion. While this hasn't stopped Congress from spending with reckless abandon before, it does make the threshold for economic malaise higher as far as what would tip the scales and force Congress to vote through a stimulus package.
This leads me to my conclusions on what policies will be pursued in 2017. They follow up on my stance that the economy is very weak. It also is in congruence with my bearishness on equities. I expect the economy to continue to get weaker in Q4 and 2017. The decrease in strength won't necessarily be unlike what we have seen all year, but it will start to matter for stocks because after the election the Fed will no longer need to pretend the economy is strong to protect the incumbent administration. When policymakers and politicians begin to acknowledge the economic problems I have been talking about all year, stocks will fall.
After stocks fall, there will then be a monetary and possibly fiscal policy to counteract this situation. It may come in the form of QE4 and infrastructure spending. I can't say with 100% certainty what the response will be, but it will be similar to this. After these actions are taken, the market will rally. However, this will be the final hurrah because it will soon be evident that QE and fiscal stimulus aren't working. At this point the final straw will break the camel's back and the market will lose faith in policy makers and the final crash lower will occur.
What To Do
My own positioning and recommendation are to avoid stocks and bonds and instead own gold (NYSEARCA:GLD) and bitcoin (Pending:COIN) to protect yourself from this downside. I wouldn't try to time the bounce in stocks when monetary easing and fiscal stimulus are announced because the market will be very volatile. The very fact that the Fed is talking about buying corporate bonds and stocks shows you the shape of the American economy. These actions would be unthinkable prior to the 2008 financial crisis. They show that we have never fully exited the crisis period. The next recession promises to be worse than the prior one as the Fed has used up its tools (interest rates are at 0) and confidence in it has waned because QE has proven futile to combat economic weakness.
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.