Inflationary Bust Or Deflationary Bust? What Will The Fed Choose?
Summary
- Decision time.
- A path, and precedent, have been set.
- How long will this path continue?
Introduction
For better or worse, it appears that the Federal Reserve is set on a path where they raise interest rates only at meetings that are followed by formal press conferences. This is the precedent set by the Janet Yellen Federal Reserve, and it looks like Chairman Powell will follow suit. Effectively, this locks the Federal Reserve into four interest rate increases, at most, during a calendar year.
With an interest rate increase predicted for the June meeting, what is the path for the rest of the year?
Will the Federal Reserve get behind the curve, providing a spark for inflation, or will they engineer a deflationary bust?
Robert P. Balan posed this question in a recent SA article, and I think it is one that all market participants should attempt to answer.
The following is my take.
Thesis
The Federal Reserve has slow played interest rate increases thus far, engineering the slowest tightening cycle in modern market history, and thus, the Fed, is likely to stay behind the curve.
An Epic Bull Market Without A Speed Limit
Nine years into one of the longest equity bull markets in modern market history, the Federal Funds rate, today, is still below 2%, sitting currently at a target range of 1.50%-1.75%.
For perspective, this is lower than the Fed Funds rate following the bankruptcy of Lehman Brothers, in the midst of the 2007-2009 financial crisis. Thus, it is an understatement to say that short-term interest rates have been accommodative.
(Source: St. Louis Fed)
Looking at the chart above, there has never been a previous tightening cycle that is remotely close to the current one. Think about that for a minute.
Have low interest rates artificially inflated the U.S. stock market?
With the premise that a picture says a thousand words, I will provide a chart of the S&P 500 Index, as measured by the SPDR S&P 500 Index (NYSEARCA:SPY), and let you decide.
(Source: Author, StockCharts)
Clearly, at the very least, low rates have not been an impediment to a record-breaking U.S. stock market advance.
What happens to equity prices when interest rates normalize?
We are in the process of finding out the answer to this question right now.
Where Should The Fed Funds Rate Be?
The Taylor Rule is a rules-based, formulaic approach to monetary policy, and its advantages are that it removes the emotion from monetary policy decisions, and it removes biases that FOMC members may harbor.
What does the Taylor Rule say right now?
(Source: Author, Federal Reserve Bank Of Atlanta)
Using almost any set of common assumptions, the Taylor Rule prescribes a materially higher Fed Funds Rate today. In fact, using a common set of inputs, the Taylor Rule is prescribing a Fed Funds Rate target of over 4% today, as shown in the chart above.
Obviously, this is an aggressive Fed Funds Rate target, particularly given the current pact of interest rate increases, and if it was implemented, the current yield curve would already be inverted if long-term current interest rates stayed where they are right now with higher short-term rates. This is not a given, of course, since higher short-term rates are one of the best indicators of higher long-term interest rates.
Importantly, looking at the chart above, it is obvious that two different Federal Reserve regimes, and now potentially a third, have structurally chosen a different path for interest rates than those dictated by common rules-based approaches.
What are the consequences, and what have been the consequences, from this conscious choice of keeping short-term interest rates artificially low?
What Will Interest Rates Be?
At the current juncture, another 25 basis point Fed Funds rate increase is virtually a lock at the Fed's June 13th, 2018 FOMC meeting. From there, market expectations are vacillating between one and two 0.25% rate hikes for the remainder of 2018.
The most recent "dot plot" suggested two more interest rate increases for all of 2018, so that would leave one more interest rate increase after June's projected hike.
(Source: Federal Reserve)
However, there has been a growing probability of four total rate hikes for 2018, and this is best expressed by the CME Group's (CME) CME FedWatch Tool, which is illustrated below.
(Source: CME Group)
The probability of four total rate hikes in 2018, has increased over the past month, and this probability indicator will be an important metric to watch going forward.
(Source: CME Group)
Economic data, measures of credit & liquidity, and the level of the stock market, will ultimately, drive interest rate policy decisions going forward.
The bond market, for all its manipulation via central bank purchases over the course of the current bull market, is already projecting higher short-term yields, as indicated by 2-Year Treasury Yields.
The Fed Is Watching The Yield Curve
The last thing the Federal Reserve has wanted to do, in my opinion, under Bernanke, Yellen, and now Powell, is short circuit the anemic economic recovery, which has been the second slowest economic recovery in the post World War II era.
Building on this narrative, there is a fear embedded in the Federal Reserve think tank of tightening too early, and recreating the 1937 downturn.
Thus, I am speculating, that the Fed is watching the yield curve like a hawk, and projecting they will be very hesitant to invert the curve. With only 45 basis points of spread between 10-Year Treasury Yields and 2-Year Treasury Yields, there is not a lot of room for future interest rate increases beyond what is already priced into the bond market.
(Source: Author, StockCharts)
However, if longer duration interest rates increase, as shown by the charts of the 10-Year Treasury Yield and 30-Year Treasury Yields below, it would give the Federal Reserve more leeway to increase short-term interest rates, and not invert the yield curve.
(Source: Author, StockCharts)
If the U.S. stock market trades sideways, or enters a full-fledged correction, and commodity prices continue to increase, could the yield curve actually steepen, as expectations of short-term rate increases actually decrease?
Closing Thoughts - A Sample Size Of One
We are watching history in financial markets in so many instances, and interest rate policy is no exception.
Never before has the Fed Funds Rate been held so low, for so long.
Clearly, a Goldilocks environment, which existed for much of the current U.S. equity bull market, particularly from early 2011 through early 2016, consisting of lower commodity prices, low wage pressures, and low interest rates, which facilitated stock market buybacks, has allowed FOMC voting members tremendous leeway in setting the Fed Funds Rate at a lower level than indicated by rules-based interest rate policy.
What have been the intended consequences of these premeditated policy decisions?
What have been the unintended consequences?
Most importantly, what is the impact of a normalization of monetary policy?
To close, I would submit that a normalized U.S. equity market, in terms of volatility, and valuations, is one direct consequence of a normalization of interest rate policy. As volatility in the financial markets increases, it is my prediction that the Fed undershoots their projected tightening schedule, consistent with their policy course over the current bull market. If this happens, it should steepen the yield curve, and further change the already changing investing landscape.
For further perspective on how the investment landscape is changing, and for help in finding under-priced, out-of-favor equities, consider joining a unique community of contrarian, value investors that have weathered the storm and become closer as a collaborative team of battle-tested analysts. Collectively, we make up "The Contrarian," my premium research service.
For further perspective on how the investment landscape is changing, and for help in finding under-priced, out-of-favor equities, consider joining a unique community of contrarian, value investors that have weathered the storm and become closer as a collaborative team of battle-tested analysts. Collectively, we make up "The Contrarian", my premium research service.
This article was written by
KCI Research, aka Travis, has been a financial professional for over 20 years. Formerly a director of research at a mid-sized RIA, and one of four strategic investment decision makers at one of the largest RIA's in the United States, Travis founded his own boutique investment firm in February of 2009. He specializes in against grain investing backed by real-world wisdom and experience by targeting out-of-favor, contrarian investment opportunities.
Travis is the leader of the investment group The Contrarian where he shares premium research and uncovers investment gems hidden in plain sight. Travis shares an all weather portfolio for minimal volatility along with a concentrated best-ideas portfolio Learn More.Analyst’s Disclosure: I am/we are short SPY AS A MARKET HEDGE. 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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Comments (26)
Between 1999-2012 you made efectively zero on the stock market. The stock market had a lot of ground to make up after 2012, or it wouldn't even be worth investing. After all, that's 10-12 years of your investment life lost. In affect, if you got in to the market in 1999-2000, the bullmarket only started in 2013, at which time around 2013, you got even again. In fact, again using the same chart, reversion to the mean incline would make it around 235. It's 260 now, so it's right in the ball park. Going back further to draw a lower revision line doesn't work because the previous market doesn't take into considertion the growth of the tech industry.This is probably really wrong on my part, but as a simple investor, losing 10 years of your investing time between 1999-2012 really doesn't mean along bull market is unsustainable (or that is sustainable). Moreover, if the "bull" market really started in 2013, like I suggest above, and as such, it's 5 years old, not 9 years old.
if nothing else, you "shoot well" and your character is very entertaining.
too many people over extended regarding credit so
FEWER purchasing $$'s going forward as credit tightens.
lower DEMAND = DEFLATION!!!
money in the hands of the rich is NOT SPENT!!!
it is simply a means to making more money via the stock market.
MAIN STREET suffers but things will get CHEAPER!!! as margin compression
overtakes all product and service arena.
DEFLATION will be followed by some form of hyper inflation as the fed
over reacts. ultimate outome? either a severe move toward socialism(freebies)
or civil unrest.
They will vote for higher taxes to pay for National Health Insurance/socialized Medicine and subsidized College tuition. And also gun control.
when they are enacted in a hurried manner.
Just look at your credit card interest rates, as they have
been trending upward at an alarming pace.
There is no reason for this rush to increase the Federal
Reserve interest rates, except to pump up the already more
than solvent large banks.
Less is more for all.
From there rates will be pulled down by gravity to Germany & Japan and the declining
SPX.
Dividends seekers will rock & roll.
You cannot make money on an old 78 record, or dividends from radio stations.
You have to be on the road.
You have to perform in your own show.
