Why Are Expectations (Sentiment) Changing So Fast?
Expectations of monetary tightening have been changing rapidly, following the swings in the stock market. As the S&P 500 (SPY) was making new all-time highs, the expectations of monetary tightening over the upcoming year were as high as 90 basis points, indicating 3-4 more rate hikes were essentially priced in.
When the market started to decline, rate hikes were quickly removed from the market and expectations went as far as to expect a rate cut. Now, with the equity market bouncing, the market is back to expecting one rate hike (22 bps) over the next four quarters. Why are expectations of monetary tightening changing so rapidly?
Can the fundamental data truly be changing that dramatically? Let’s take a look at why expectations are changing so rapidly. Is the stock market the sole barometer for monetary policy in the modern era?
Fed Near Term Forward Spread:
The guide for these expectations can accurately be measured by the Fed Near Term Forward Spread [FNTFS], graphed above. The FNTFS takes the difference between the Treasury rate that matures in six quarters and the Treasury rate maturing in one quarter.
Essentially, the spread takes the difference of the Treasury rate maturing in 1.5 years versus the 3-month Treasury rate which is tethered fairly closely to the Federal Funds rate. This is used as a proxy for where the market expects the 3-month Treasury rate (Fed Funds rate) to be one year from today.
As the chart above shows, in September, the market was forecasting the Fed Funds rate to be up to 90 basis points higher in the next four quarters. As soon as the stock market started to decline, that expectation changed rapidly, and the spread went negative.
If the market is pricing the Treasury rate 1.5 years in the future lower than the Treasury rate three months in the future, that is an explicit bet that the FF rate will be lowered.
If you look at the FNTFS and the effective Federal Funds rate, you will see how in the past 20 years, each time the FNTFS went negative, the FOMC did in fact cut interest rates in some capacity.
Fed Near Term Forward Spread Vs. Fed Funds Rate:
If not for the stock market, why did expectations change so dramatically and will the market be wrong for the first time in 20 years? Is the Fed not going to cut rates in 2019? Judging by the stock market, a rate hike is back on.
Look how closely the monetary tightening expectations have tracked the S&P 500.
Fed Near Term Forward Spread Vs. S&P 500:
If we look strictly at the dual mandate, unemployment and price stability (inflation) from September to today, should expectations have changed that dramatically?
In September, the unemployment rate was 3.7% and core PCE, the Fed’s preferred inflation gauge, was 1.96%. Today, the unemployment rate is 3.9%, and core PCE is 1.90%.
Now, I don’t think these are good metrics to go by, and I don’t advocate their use in conducting monetary policy, but those are the rough guidelines by which the Fed is supposed to operate.
Given that those “key” metrics have not changed much from September through the present, what are we to believe in terms of what will truly guide monetary policy?
If the stock market makes a new all-time high, rate hikes will certainly resume. If volatility in the stock market persists, the market will force the Fed’s hand and not allow any more rate hikes.
It was not just the market that changed expectations, FOMC members were nearly tripping over themselves to change from a forecast of three rate hikes in 2019 to a “pause” being necessary and the potential cessation of Quantitative Tightening.
Does future monetary tightening matter at this point? I recently penned a two-series article titled, “The S&P 500 Will Push The Federal Reserve Too Far” in which I argued that monetary tightening had already gone too far for such an overindebted economy.
I am not a fan of low interest rates, and I believe they encourage the build-up of unproductive debt, but that does not mean the Fed can raise rates without repercussions.
Each cycle, the Fed stops raising rates at a lower terminal rate because an economy with increasing levels of debt starts to have issues at lower rates of interest.
Fed Funds Rate History:
At just 2.5% interest on the FF rate, we already see issues in high-velocity sectors of the economy that are tied to interest rates.
In economist Lacy Hunt’s Q4 review, which you can read by clicking here, he wrote:
It is now evident that the Fed actions have spread through the financial sector into the broader economy as inflation wanes, and the growth rate in the interest-sensitive bellwether sectors such as housing, autos, and capital spending is either slowing or declining.
As 2018 ended, several high-multiplier sectors appear to have either passed their cyclical peaks or rapidly approached them. Exports, vehicle sales, and home sales exhibited characteristics of sectors in recession. Capital equipment and oil and gas drilling have also lost considerable momentum and, while remaining positive, their leading indicators are deteriorating.
Even without any additional rate hikes, the economy is already experiencing restraint. Hunt wrote:
Going forward, the economy will face past and continuing restraint of monetary actions. First, the flatter yield curve means that financial entities that borrow short and lend long will find their activities less profitable and will slow activity or increase risk premiums, and thus credit will become more expensive or less readily available. Second, world dollar liquidity [WDL] continues to decline. Third, the velocity of money, following a mild four-quarter advance, fell in the fourth quarter, possibly restarting its multi-year downtrend. Fourth, monetary restraint in the form of Fed balance sheet reduction will tighten financial conditions.
The FOMC is letting the S&P 500 guide policy without looking at the impact that higher interest rates are having on critical interest rate sensitive sectors of the economy. If the stock market remains the driving factor of monetary policy, expect more wild gyrations.
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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.
Additional disclosure: I have an underweight exposure to SPY