The Fed's Third Mandate

Includes: DIA, QQQ, SPY
by: Lawrence Fuller

The Federal Reserve has a dual mandate to promote maximum sustainable employment and price stability. In its attempt to achieve these objectives, it has lowered short-term interest rates to zero and embarked on a quantitative easing campaign over the past four years that is unprecedented in its size and scope. The Fed has communicated that it has two objectives with respect to its asset purchases. The first is to lower the long-term interest rates that dictate borrowing costs in order to stimulate loan demand. The second is to lower the yields of the most conservative financial assets, creating negative real rates of return in order to force investors to purchase higher-yielding and higher-risk financial assets, namely stocks. The hope has been that investor demand would inflate higher-risk asset values, creating a wealth effect that would stimulate spending on goods and services. The increased demand for loans and for goods and services would lead to faster rates of economic growth, resulting in job creation. This is the script from which the Fed has been reading for the past several years.

I believe that the Fed has a third mandate, which is to promote, if not ensure, the stability and credibility of our financial market system as a whole. Both became preconditions to achieving its dual mandate when the Fed decided to use the stock and bond markets as conduits for its policies. The Fed must realize that if the public at large does not believe that our financial markets are fair or credible, and that stock market gains are conjured or unsustainable, participation will wane and thus nullify to a large degree the wealth effect that the Fed hopes to achieve. This is clearly what has happened over the past four years based on fund flows, as the investing public has gorged itself on the perceived safety of fixed income.

Some will charge that stability and credibility are responsibilities of the Securities & Exchange Commission, but I believe that both are responsibilities that the SEC now shares with the Federal Reserve following the passage of the Dodd-Frank Act. The Fed is now responsible for increased oversight of all banks with more than $50 billion in assets, which includes firms like Goldman Sachs (NYSE:GS), JPMorgan (NYSE:JPM) and Citigroup (NYSE:C). It is pumping trillions of dollars of OUR money through the veins of institutions like these. Considering the fact that these too-big-to-fail banks are also the largest and most influential investment firms on Wall Street, it is fair, if not necessary, to charge the regulator-in-chief of these financial behemoths with the responsibility of maintaining stable and credible financial markets.

The Fed has failed miserably at upholding what I have described as its third mandate. Instead, its quantitative easing programs over the past two years have done nothing but lead to an instability in stock and bond markets that has undermined the objective of achieving the sustainable economic growth necessary to promote job creation and stable prices. I also see evidence that its activities will destabilize the recovery in housing. Instability leads to uncertainty and volatility, which depress the appetite to take risk, expand, spend or hire. We are now seeing the earliest stages of consequence for these policies in the most levered and speculative segments of the bond market, which is having a ripple effect throughout all fixed-income segments on a global basis.

Bond prices have plunged, pushing interest rates on Treasuries and mortgages to their highest level in more than a year. Some argued that the rise in rates is due to speculation that the Fed will taper its rate of bond purchases before the end of the year, irrespective of whether or not its unemployment rate target is met. Others suggested that the rise in yields is indicative of expectations for higher rates of economic growth and inflation. I am certain that the rally in the Japanese yen and coincident decline in the Nikkei is also a significant factor. Here is the best reason of them all in my view: long-term interest rates are too damn low! The yield on the 10-year Treasury bond is well below what current free-market economic conditions would dictate. This has encouraged speculation and leverage. Now we are watching it unwind.

The Fed has indirectly distorted prices in nearly every segment of the fixed-income market as a result of its yield-compression investment activities. A good example was the recent historic low in junk bond yields of 5% in early May. The volatility that we are experiencing is a preview of what's to come on a recurring basis as long-term interest rates eventually normalize. What's normal? In my view, based on current rates of nominal economic growth, the 10-year Treasury should be yielding 3.5 - 4.0%. Perhaps it takes several years to normalize. Perhaps it takes six months. No one knows. What we do know is that the Fed will not be able to steer long-term interest rates on a gradual and steady path towards normal. The idea that investors will calmly sell their fixed-income securities and rotate into equities, in what has been dubbed the "Great Rotation," is the type of fantasy-land forecasting that only Wall Street can construct.

Therefore, every time we see a surge in rates, consternation will swell over how the army of individuals that invested more than $1 trillion in bond funds over just the past two years will react. Will they all head for the exit at once? Additionally, many investors have likely ventured into sectors of the fixed-income market through closed-end funds and ETFs where they have little experience, are uncertain of what is reasonable value, and are more apt to sell indiscriminately in the face of short-term losses. The ETFs are then forced to sell indiscriminately what are often illiquid securities, leading to tremendous volatility. This will lead to investment opportunities for astute investors, but I fail to see how this quagmire is in the interest of the majority of investors or the public at large, which is who the Fed should be serving with its policies.

The Fed is quick to take credit for the housing market recovery, but I think the significant rise in home prices over the past year is far from stable. The rise in home prices has predominately been a function of the decline in mortgage rates, which has improved affordability, and not a rise in income, which has stagnated. Zillow reported last month that home prices are once again well above historical norms in relationship to incomes. What this means is that when mortgage rates rise, affordability vanishes. This is why we have seen purchase applications decline in three of the past four weeks as mortgage rates rose more than 50 basis points. Now there are indications that new supply will hit the market as banks increase foreclosures in response to home price increases over the past year. A further increase in mortgage rates, if not current rates, will likely halt any further appreciation in home prices, and possibly lead to a temporary decline, undermining one of the most important tenets of the economic recovery. Therefore, just as we have seen in the fixed-income markets, Fed policy has divorced home prices from the economic fundamentals it intended to strengthen. This will lead to instability in the housing market as we move forward.

Some investors might interpret the uninterrupted and unprecedented mechanical move upward in the US stock market indices, which began in earnest last November, as a sign of stability, but I think it looks like the exact opposite. The Nikkei Stock Average in Japan, having followed a similar pattern during that same time frame, is providing us with a preview of what we are likely to see in our own market moving forward, in terms of instability. The Bank of Japan has followed a policy nearly identical to that of the Federal Reserve, but with far more monetary force relative to the size of its economy. This led to a near 50% rise in the Nikkei that was derived predominately from monetary stimulus, rather than by being built on strengthening economic fundamentals.

Despite the continuation of that stimulus, we have now seen a bear-market decline of 20% in just the past three weeks, surrendering more than half of the gains for the year. This is because the Japanese government, just like the US government, has put the cart before the horse. Both have created a financial market dependency on stimulus that has inflated asset values, absent the fiscal policy necessary to create the conditions for sustainable economic growth that serves as a foundation for increased asset values. The horse is now trampling the cart in Japan, in the form of tremendous market instability and declining prices, which is what I think we are in the earliest stages of seeing in the US stock market.

Supporting this outlook was the stock market's adverse response to mere speculation that the Federal Reserve would slow the pace of ongoing bond purchases. If the economy is improving, as the bulls on Wall Street continue to proclaim, then the stock market should be able to stand up on its own two feet without any further quantitative easing. The reality is that the Fed has created a wide gap between stock market perceptions and economic reality, and the sobering process that follows the tapering of monetary stimulus will close that gap. In effect, the Fed's efforts to centrally plan market prices by thwarting the pricing mechanism that rules free markets will lead to greater instability as we move forward. This also does little to restore the credibility that investors all but lost during the financial crisis in 2008-2009.

I think it has become ingrained in the US investor psyche that there are two sets of rules: one set for Wall Street and another for the rest of us. Scandal after scandal has plagued our markets since the crisis, despite grand promises of reform in the years that followed. Investors are sick of it. Just this week the SEC fined the Chicago Board Options Exchange, one of our largest exchange operators, with a $6 million slap on the wrist for allowing billions of dollars worth of illegal short-selling activity through one of its member firms. There was also the revelation by the mainstream media that high-frequency trading firms are profiting from access to market-sensitive economic data that they receive prior to the rest of us.

The regularity with which we see such disrepute continues to undermine credibility in markets that increasingly disadvantage individual investors. It is clear that Fed policy has swelled the coffers of Wall Street above all else. The US banking industry, near complete collapse just five years ago, realized record profits in the first quarter of 2013, while median household income has declined 7.3% since the start of the last recession. If the Fed wants to restore credibility in financial markets, it needs to end its focus on the central planning on market prices and begin to focus on regulating its institutional participants. Contrary to what the Fed may think, I believe that recent stock market appreciation is also undermining credibility.

Over the past six months, this has been the most contrived upturn in stock prices I have ever seen. It is not that I don't appreciate seeing the equities I hold and manage rise in value, but it has occurred with an unprecedented deterioration in the technical backdrop that has left seasoned market technicians with decades of experience confounded. Volume has consistently declined on the rallies and risen on the declines. The steady decline in daily NYSE new highs over this time frame, which is a divergence that has historically always led to a market correction, was meaningless. There is the manipulative effect of high-frequency trading that no one seems to fully understand or care about, which now accounts for more than half our daily volume. Overall stock market volume continues to decline. These are not healthy signs, yet I sense the influence of an invisible hand that continually refutes the possibility of a simple 1% decline on any given trading day. What we have seen the past six months is not normal market activity in my view, and it is clearly being influenced by the Fed's open market activities. It has further damaged the credibility of our markets in the eyes of investors, which undermines participation, and ultimately the Fed's long-term objectives.

The Fed obviously does not have a third mandate, but if it did, as I have described, it would be failing to uphold that mandate. As a result, I have been concerned that the market instability resulting from its policies would lead to a collapse in the gap between the perception that it is trying to create and the reality over which it has little control. That process appears to have started. It is and will continue to present investment opportunities in equities and fixed income for investors who have liquidity. Now is the time to be building an inventory of investable securities in every asset class with entry prices that are based on sound fundamentals and a realistic global economic outlook, rather than a continuation of the momentum fueled by misguided monetary policy.

Disclosure: I 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.

Disclaimer: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.