Could The Fed End The Stock Rally?

Summary

• The Fed could trigger a recession and a considerable stock market selloff if it tightens too much.
• We doubt there is much need for that given the fact that inflation is still very well behaved.
• In fact, in a world plagued by deflationary forces and high debt levels, a little inflation isn't actually much of a problem.

The Fed is on a tightening path but, as some suggest, in the absence of accelerating inflation this could well risk an unnecessary recession and a considerable stock market sell-off, so let us investigate the issue.

In a previous article we noted the more or less synchronized recent upturn in the world economy, which seems to offer a good backdrop for tightening monetary policy.

Indeed, central banks, if they haven't tightened policy already, are certainly making a lot of noise in that direction, which has been blamed on a little 'taper tantrum' on the bond markets, from CNBC:

Since June 26, the U.S. 10- year yield has risen from 2.12 percent to Thursday's high of 2.38 percent. The move has been global, after European Central Bank President Mario Draghi last week pointed to a less risky outlook for the European economy, and Fed officials made consistently hawkish remarks. Some of those officials said they were even concerned that their policies created a too easy financial environment, meaning interest rates should be higher.

In fact, bond yields are likely to be rising on both the synchronized upturn in the global economy and the prospect of monetary tightening. See the upturn in PMI figures basically everywhere:

It should also be noted that the monetary tightening isn't a general phenomenon, and some banks aren't taking the rise in yields lying down, from Business Insider (our emphasis):

In order to prevent a rise in yields of a magnitude seen in other markets, the Bank of Japan (BoJ) went all-in earlier today, pledging to buy an unlimited amount of 10-year bonds at a yield. It also upped its buying of JGBs maturing within 5 to 10-years, increasing its allocation from 450 billion to 500 billion yen. The BOJ, as part of its quantitative and qualitative monetary easing (QQE) with yield curve control program, currently buys JGBs in order to anchor 10-year yields at around 0%.

We don't know about you, but "pledging to buy an unlimited amount of 10-year bonds at a yield" doesn't sound like tightening to us. A nice (for the Japanese, at least) side-effect is that this shoots the yen lower, which is good for stocks (as we have advised to buy Japanese stocks at various points here at SA). Here is dollar/yen:

The Fed

The previous Fed Chairman Ben Bernanke thinks it is a mistake to increase rates and start unwinding the balance sheet at the same time. He argues that the Fed should raise rates first, the balance sheet can wait.

Higher rates give the Fed room to lower rates in times when this is needed, and there is something to be said for this.

However, there are several reasons to argue why tightening might not be a good idea in general:

• US inflation and wage growth suggest inflation isn't a serious threat.
• Substantial amount of leverage, especially in emerging markets.
• Fed shrinking its balance sheet will shrink the balance sheets of banks as well.
• Long-term structural problems.
• Asymmetrical risks

There are those that argue that the Fed is making a mistake in raising rates already. Evans-Pritchard notes that average US job growth over the last three months has dropped to a 5-year low of 122,000, although one should add that it has perked up a bit since.

Others have noted that the Fed seems hell bent on increasing interest rates and start unwinding its asset portfolio (a leftover from earlier QE policies), despite the fact that inflation is still behind its 2% target and on some measures actually falling.

Indeed, there is something to be said for this as well:

Importantly, falling short on the inflation side suggests to many economists the Fed is also allowing the US labor market to operate below its full potential, despite a historically low 4.3% unemployment rate. Long-term joblessness and involuntary part-time unemployment remain unusually high and labor force participation is near multi-decade lows. Wages have also been stuck in place for a long-time for most of the American middle class.

We also see low inflation in other parts, like commodities, although the graph below, which is remarkable in itself, probably reflects the expensiveness of equities quite as much, if not more so than the low price of commodities:

And it's not just commodities, housing as well (which at 18% is the biggest component of core personal consumption expenditures, or PCE, which is a more reliable predictor of future inflation compared to the CPI, according to the Fed). So what happened to core PCE? Well, from Credit Suisse:

Core inflation has just been through one of its weakest three-month stretches in the past 60 years. In annualized terms, core CPI has averaged just 0.05% and core PCE 0.27% (Figure 2). The FOMC has singled out several “transitory factors,” they believe to be driving the recent weakness. In particular, chair Yellen cited poor inflation data for mobile telephone plans and prescription drug prices.

However, excluding mobile phone plans and pharma:

And here is housing PCE

So it looks like below 2% low inflation isn't just due to transitory factors, as the Fed claims. The problem is that nobody really knows for sure. Past models seem to have lost some of their relevance. The Fed itself is internally divided on this, what should mere mortals like us make of it?

Brave new world?

It looks like low inflation is here to stay, at least for the foreseeable future, despite 4.4% unemployment in the US.

This is part of a brave new world in which an increased supply of world savings (mostly the result of demographics) and reduced investment demand (due to slower growth, itself to a considerable part caused by worsening demographics) leads to a world savings glut which has ratcheted interest rates inexorably downwards in developed countries:

Here is another thing to consider

This comes from Wolf Street, who noted that the employment/population ratio ratchets downward in recessions, but since 2000 it only recovers a part of the lost ground during recovery's, a new phenomenon.

Basically this means that, for whatever reason, recessions are considerably more damaging than before.

In this light, it is even more curious why there isn't more wage pressure given the low employment. Part of labor supply has, for whatever reason, withdrawn so effective supply is less.

How should the Fed react?

This situation puts the Fed in an awkward dilemma. If it tightens too much, it could keep the economy into an unnecessary recession. Unnecessary as the inflation danger might very well not have been very significant.

If it tightens too little it risks getting behind the curve but, as we asked in another article, what curve exactly? In the traditional thinking that still seems to dominate Fed thinking this is the Phillips curve, in which lower unemployment will lead to wage and price pressures.

This is supposedly happening when unemployment falls under the natural rate, but what the natural rate is, nobody really knows with certainty. As shown above, there are, as of yet, little wage and price pressures emerging, despite unemployment being at 4.4% which in previous times would have set these off at least to some extent.

What we can say is that the risks of doing too much versus doing too little don't seem to be symmetrical. Tightening too soon and too fast seems to carry a considerably greater risk than tightening too slow in the present climate of low inflation.

But is this the way the Fed sees it? They seem to want to tighten for two reasons:

• Low rates boost asset prices and can lead to asset bubbles.
• Higher rates gives the Fed the necessary space to lower rates considerably when that recession finally happens.

It would be ironic if the Fed itself is the main driving cause of the next recession though. We think things don't have to be that complicated. Let them wait with the tightening until there are more definite signs of inflation starting to misbehave. In a world full of deflationary forces (demographics, slow growth, technology, etc.) and high debt levels, a little inflation could actually be benign.

Analyst’s 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.