The Fed's Hand Of God Move To Raise Interest Rates

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After years of remarkable strength, the U.S. stock market is due for a respite.

The Fed’s unorthodox rate move has led to a decoupling of interest rates from money supply. This dovish approach will continue to hold sway at the central bank.

I am cautiously optimistic that the bull market will remain intact over the coming years.

If investors want to dwell on one worry for 2016, the Bible might offer some guidance. It records that 7 years of plenty were followed by 7 years of lean. This is an ominous tale because the incredible run in U.S. equities saw its seventh birthday last month. As the bull market is entering its eighth year, there is reason to be cautious - more so than ever, given the Federal Reserve (Fed) is now on track to raise interest rates.

But as I have stressed many times here on this platform before, the Fed will continue with its ultra-loose monetary stance come what may, and this will keep a floor under share prices. Many investors have yet to wake up to this fact. My view is that going into 2016, "buying on dips" will continue to be a sure-fire prescription for making money on Wall Street, so long as you are willing to brave the uncertainty and fish the bottom.

Where the heck is tightening?

On 16 December last year, the Fed lifted its benchmark policy rate for the first time in nearly a decade. Yet such a move was more symbolic than substantive. Without asset sales from its balance sheet, the U.S. central bank in effect is keeping the massive QE (quantitative easing) liquidity in the market. Since banks are still chock-full of excess reserves, the 25-bp rate hike was made possible only because the Fed increased the interest rate paid on reserves from one-quarter to one-half percent. This was a creative move, but boiled down to the essentials, it is nothing more than the Fed paying money out to stage a phony rate hike - phony because even more money is added to the economic system.

As we can see from Chart 1, monetary conditions (as measured by M1 and M2) remain highly accommodative following the December rate rise. Looking at Chart 2, we also see that the reverse-repo program, the Fed's new framework for implementing monetary policy, is by no means tight. With so much money chasing so few quality investment opportunities, it is still going to be hard for the stock market to perform badly. Cash-rich investors, for one, will take advantage of every downturn to do bargain hunting (see Chart 3).

That said, even if the Federal funds rate were to rise further, the impact would be more psychological than material. It is because the normal link between money supply and interest rates does not hold under the Fed's new interest-rate control mechanism. Higher interest rates do not necessarily imply tighter money.

And that is where the catch lies: Take interest rate equals 3% for instance. When money is scarce, investors need to borrow to make a purchase, but when money is abundant, they can use their own money instead. In reality, taking out a 3% interest rate loan is different from forfeiting a 3% interest rate deposit, although theoretically speaking the so-called "opportunity cost" are the same in both situations.

But with some USD2.5 trillion of reserves sitting on the Fed's book, it is questionable how much liftoff on rates (of this kind) the Fed can provide. To take a rough guess, should interest rate go up to 4%, then interest payments on reserves would amount to USD100 billion a year. This would erase all of the Fed's 2015 earnings (USD100.3 billion - to be exact), most of which were derived from the interest income on securities acquired through QE.

All told, there are limits to how far such tightening can go. Paying higher interest on reserves not only will squeeze the central bank's budget. It is also conceivable that long before the interest rate reaches the 4% threshold, the Fed will come under heavy fire for handing out taxpayers' money to private banks. My assessment is that three to four more 25bp rate increases are the farthest it can go.

That is sufficient, however. By all accounts, the Fed's new approach to monetary policy is just an expedient to silence the critics that it has delayed the start of policy normalization for too long. The purpose is to foster an impression that interest rates are returning to normal. There is indeed no point in starting a tightening cycle when inflation still lingers beneath the Fed's 2% target.

Normalization will play out over many years

Having said this, I stick to my belief that the Fed will not make any bold move in the run-up to November's election, and that only after 2016 will the Fed start unwinding its bond portfolio. Going ahead, the FOMC might put through a few more pseudo rate hikes, but benign monetary conditions should remain the order of the day. Only until the Fed has sold off a good part of its bond holdings, and bank reserves consequently come down to lower levels, will there be a real return to normalcy.

What is worth noting, however, is that there is no telling how long that will take. Could be years. Could be decades. But until then, well, the market will continue to be flush with liquidity. Furthermore, my hunch is that a sizable fraction of mortgage-backed securities in the Fed's mega portfolio has long gone sour. Because the Fed can never sell back all these so-called "toxic bonds" to the market, a substantial part of the QE liquidity infusion may therefore last ad infinitum. Against this background, I stand by my theory that the Fed is counting primarily on high growth and high inflation to absorb the excess liquidity.

As is evident from Chart 4, thanks to continued economic growth, money base as a percentage of nominal GDP has fallen in recent quarters. This, remember, is despite no outright selling of bonds to reduce the Fed's balance sheet. Slowly but surely, things are unfolding just the way the almighty Fed would probably like.

So with time - and only time - can the Fed do away with QE. In the months (or even years) to come, the amount of capital made available by the Fed will continue to support the economy and the stock market. Chances are good that this year and the next will bring continuous good times. As noted earlier this month by former Fed chair Ben Bernanke on a historic panel discussion with current chair Janet Yellen and past chairs Paul Volcker and Alan Greenspan, "Just because we've been in 7 years of recovery doesn't mean we're due for another recession at all." This is quite a statement. Perhaps the Bible is getting the U.S. economy wrong.

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.