Will The Fed Shock The Markets?

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by: Bruce Carlson

Summary

Currently, the market is skeptical that the Fed will move at the March meeting.

The main arguments are that the move is not fully priced in by the market, and that the Fed has moved extremely slow and hesitantly post the financial crisis.

This assessment could be significantly wrong as their reaction function is shifting.

The Fed has been extremely tentative in tightening financial conditions in the post financial crisis time period mainly because of slack in both the domestic economy and abroad. Because of this, they have consistently disappointed the market in matching their forecasted tightening moves in the time frame expected, generally citing financial market conditions as a reason to be cautious.

The conditions underlying this reaction function are rapidly changing, and the Fed is actually starting to acknowledge they are behind the curve in removing this stimulus.

If we look at a chart that displays the real fed funds level overlaid with the unemployment rate (inverted), we can see that the level of stimulus is unprecedented on both an overall basis and especially at this point of the economic cycle.

The linkage here is that the real fed funds should be negative in recessionary periods with high unemployment and should be positive late in the economic expansion when the employment rate is low. What we see here is the reverse, extremely negative real fed funds in a period of full employment (barring the low participation rate).

Data Sourced from the Federal Reserve (FRED)

To better exemplify this, we can break this down to a Fed Policy Indicator, where higher the level, the tighter the policy, and the lower the easier the policy.

Chart compiled from data sourced from the Federal Reserve and my own calculations.

As we can see by both the level and by the extended period (area under the curve), the amount of stimulus is unprecedented over the last 50 years. While we implicitly know this because of quantitative easing programs it helps to demonstrate the level and amount. The current levels of stimulus are akin to what we saw in the depths of the recessions of the '70s and dramatically greater than the amount seen in the early '90's period of slow growth.

So why does this mean the Fed will react differently? The main reason is that even though the Fed has hiked 50 bps, core inflation (CPI x food and energy) has accelerated by 60 bps since May of 2015, effectively fully neutralizing this tightening in the Fed Funds. In addition, the unemployment rate has dropped from 5.5% to as low as 4.6% in November or .9% over that time period.

So effectively, we have an economy with dropping unemployment, accelerating inflation and a level of stimulus equivalent to the depths of the deepest recessions over the last 50 years. In addition, we have a stock market at cyclically adjusted P/E ratios that were only surpassed in 2000's Tech Bubble and 1929's great stock crash, with a Presidential administration that has proposed significant fiscal stimulus spending, a stimulative tax policy, and an inflationary border tax. This is a Fed that is significantly behind the curve, and their latest commentary is just beginning to acknowledge this fact.

Currently, the CME Fed Pricing tool has a 22% chance of a move in March, a 50% chance of at least a quarter-point move in May and a 66.5% chance of at least a quarter-point move in June. These probabilities are too low, and I expect Fed language to immediately ratchet up these expectations. While they may be too timid to push the expectations up in time for a March move (given the low probability currently priced into the market), they need to move expectations to near 100% for the June meeting, which would also push up the nearer-term probabilities.

I expect a dramatic change in Fed language immediately and a more aggressive tightening program than is currently priced in the market.

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.

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