Avoiding Asset Bubble 3: What It Means For The Market

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Includes: DIA, IWM, QQQ, SPY
by: Vlae Kershner

Summary

Fed policy has allowed two asset bubbles to occur before they were rapidly deflated with higher interest rates.

The new data-driven approach seeks a balance between stopping bubbles and avoiding a downturn.

The most likely result is a trading-range market.

Is the Fed telling the market, "just behave"?

Ever since former Fed Chairman Alan Greenspan spoke of "irrational exuberance" in 1996, referring specifically to the boom and bust in Japan, the danger of asset bubbles has been on the central bank's radar.

Still, policy remained more geared to the mandated goals targeting inflation and unemployment, and policy allowed the formation of two asset bubbles.

Now, though, bubbles are no cause for champagne. The Fed is all but congratulating itself on the stock market's recent decline.

James Bullard, St. Louis Fed

Photo: James Bullard (St. Louis Fed)

In a presentation at New York University last week, Federal Reserve Bank of St. Louis President James Bullard hinted at a bubble-pricking policy. According to the Fed's summary:

Bullard then discussed how the risk of asset price bubbles over the medium term has been reduced. "Steps toward normalization of U.S. monetary policy help to lessen the risk that very low interest rates might feed into a third major asset price bubble in the U.S.," Bullard said, adding, "The recent sell-off in global equity markets, along with increases in risk spreads in corporate bond markets, may have made this risk less of a concern over the medium term."

The "third bubble" he's talking about refers to two others that weren't stopped until too late:

  • The tech bubble of the late 1990s. The Fed started raising rates in 1997 but the increases were more than wiped out by reductions during the developing-market crisis of 1998. By the time rates started rising again in 1999, it was too late to stop a full-on bubble.
  • The housing bubble of the early 2000s. The Fed was late to the party and late to leave. Rates didn't start rising until 2004 and didn't stop until June 2006, two months after housing prices peaked in April 2006.

It took until September 2007 for the Fed to begin lowering rates, after the first of several financial crises had already occurred.

It's the market's memory of how the Fed used a mechanical rate-raising approach to stop that Bullard says caused the recent selloff after the December 2015 rate increase and the belief a series of increases were inevitable.

Bullard noted that the FOMC has repeatedly stated in official communication and public commentary that future monetary policy adjustments are data dependent. He addressed the possibility that the financial markets may not believe this since the SEP may be unintentionally communicating a version of the 2004-2006 normalization cycle, which appeared to be mechanical.

"Post liftoff, communicating a path for the policy rate via the median of the SEP could be viewed as an inadvertent calendar-based commitment to increase rates," he said. "While the Committee has certainly stressed data dependence, its past behavior belies that emphasis and therefore may not carry as much weight as it should with the financial markets."

Instead of initiating a boxing match with Wall Street--"don't fight the Fed, there's more rate increases coming"--the central bank wants judo--whichever way the markets move, it will take a countervailing action. In addition to its congressional mandates of targeting unemployment and inflation, it now has a third objective, financial market stability.

What it means: If the S&P breaks out on the upside, expect the fear of Asset Bubble 3 to cause multiple rate increases. If the January selloff turns into a full-fledged bear market, expect soothing words if not an out-and-out reversal of the December rate hike.

The result of such a policy could be a lower-volatility market locked into a trading range for some time. That's good news for investors who make most of their return on dividends, not such good news for those who rely heavily on annual appreciation.

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.