The News That Market Investors Don't Want To Hear The Federal Reserve Saying

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Noted economist Mohamed El-Erian writes that the Federal Reserve is no longer the markets' best friend.

The stock market has boomed during the current economic recovery with investors believing there exists a Federal Reserve "put" and working off the mantra of "Don't fight the Fed".

What happens when the Fed ceases to be investors' "best friend" because investors begin to feel less confident that the "put" will be there when they need it?

"Markets must grasp that the Fed is no longer their best friend."

This is the headline to the electronic version an opinion piece in the Financial Times by noted economist and bond-market guru Mohamed El-Erian. "The longer markets discard the Fed's reconfirmed policy guidance, the greater the potential for asset markets to be disappointed by a central banking community that is shifting from being best friend to becoming a lot less supportive." Since the financial crisis that came about in 2008, the Federal Reserve has been the "best friend" of investors in the stock market, a friend that investors have come to count on to the extent that "Don't fight the Fed" has become the mantra of many market participants.

There have been three things contributing to this attitude. First, there was the effort by the Fed under the leadership of Chairman Ben Bernanke to stimulate the stock market in order to create a "wealth effect" for consumers that would lead them to increase spending and therefore driving the economic growth taking the United States out of the Great Recession. Second, there were the three rounds of quantitative easing that Fed officials felt were needed in order to assure that a repeat of what happened in the Great Depression did not take place during the current recovery. This also created an environment where troubled banks could exit the banking system without undue disturbance. Third, in ending the third round of quantitative easing, Federal Reserve officials did not want, at any time, to duplicate the errors of the Fed in 1936 and 1937 and create another depression, the Depression of 1937-38.

Consequently, everything it did with its policy rate of interest and with reductions in the Federal Reserve's balance sheet were to err on the side of too much ease and not err on the side to too much monetary tightness. The result was to basically establish a "put" under stock market prices. This "put" was not unlike the "Greenspan put" that investors attributed to the actions of the Federal Reserve under the leadership of then Chairman Alan Greenspan.

And, what is the "reconfirmed policy guidance" that Mr. El-Erian writes about. Well, he tells us: "the Federal Reserve did three things last Wednesday (at the latest meeting of the Federal Open Market Committee meeting) that lessen monetary stimulus, only the first of which was widely expected by markets: it raised interest rates by 25 basis points, reiterated its intention to hike (the rate) four more times between now and the end of next year (including one in the remainder of 2017), and set out a timetable for reducing its $4.5 trillion balance sheet."

The problem that has developed, as seen by Mr. El-Erian, is that "judging from market developments…traders and investors are resisting the Fed's re-affirmed forward guidance. Instead, it is betting on the repeat of the last few years during which officials have tended to over-estimate the extent of policy tightening and, in subsequently reversing course, have converged back to the lower rate path implied by the markets." That is, "judging from asset prices, markets are filing to internalize sufficiently the shift in the policy regime." Stock market prices have hit new historic highs and bond market prices have risen so as to bring on lower and lower long term interest rates.

Investors are "going with the flow" and are "not fighting the Fed."

That is, the Fed action "has fuelled even more exuberant risk-taking, with stock and corporate bonds decoupling further from economic and corporate fundamentals."

And, this is the disconnect that Mr. El-Erian is citing.

Furthermore, Mr. El-Erian believes that the changed direction is becoming worldwide:

"This is an evolving Fed that, absent a major economic downturn, will maintain a more hawkish tilt to monetary policy. And, while it is well ahead of others, it is not the only central bank undergoing such a transition. The Bank of England is also itching to tighten policies despite a weakening economy and Brexit uncertainties, and the European Central Bank may soon have to follow."

In other words, markets may have "little to cheer" in the "the recent liquidity-driven rally"

This just plays into another picture of gloom presented to us by Justin Lahart in the Wall Street Journal. Mr. Lahart writes

"There are two things investors should keep in mind about the Federal Reserve: One, it is in a tightening cycle. Two, tightening cycles almost always end badly."

"The Fed's aim is to guide the economy to a soft landing."

"But executing a soft landing is notoriously difficult."

"Moreover, the Fed's track record with soft landings is incredibly poor."

Happy news!

The question is, what happens when the Federal Reserve ceases to be the "best friend" of investors?

Since this has been the mantra of investors for such a long time, taking this guiding principle away from them is not likely to end happily.

And, this is why Federal Reserve officials continue to try and talk a good story…and be on the alert to keep their "put" in place if confidence starts to fall away. Still, as Mr. Lahart reminds us, the Federal Reserve's track record on soft landings is not that good.

Let's hope this time they don't live up to this record.

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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