The Federal Reserve is due to release their next formal policy statement
April 27 at 2:00 pm ET
Fed's Constant Assistance Is A Two-Sided Coin
The Fed stepping in to assist financial markets is not particularly new or
surprising but with a dual mandate that includes keeping inflation in check,
the central bank's "bailouts" cannot go on indefinitely. The recent Fed-assisted
rise in crude oil impacts inflation expectations, which brings to mind the
Fed's Jackson Hole keynote address by
Stanley Fischer:
"Because monetary policy influences real activity with a substantial
lag, we should not wait until inflation is back to 2% to begin tightening."
In 2016, thus far, the Fed has been content to keep rates hovering above zero.
By reviewing how they decided to put off any additional rate hikes and the
impact on inflation expectations, we can understand why the Fed's market-friendly
stance has limits, which may begin to adversely impact asset prices in the
not too distant future.
Fed May Hike Rates Four Times In 2016
In what now seems almost comical, Federal Reserve Vice Chairman Stanley Fischer
said on January 6, 2016 the Fed may raise rates four times in calendar year
2016. As a reference point, the S&P 500 opened at a level of 2,011 on January
6. Text
of the full Reuters story.
After Stocks Tanked, Fed Started To Amend Their Script
Between the "four rate hikes" proclamation day and January 20, the S&P
500 dropped from 2,011 to 1,812. By January 27, the Fed started to show some
concern about plunging financial markets. From MarketWatch:
The Federal Reserve on Wednesday expressed less eagerness to hike interest
rates, as the central bank showed concern over both the economy and the
faltering stock market.
By February 1, Stanley "we plan to hike four times this year" Fischer had
shifted to what was described as a "barely any interest rate hikes this year" stance.
In twenty-six calendar days Fischer skipped all the way from four hikes to
basically zero-to-one hike. From MarketWatch:
Federal Reserve Vice Chairman Stanley Fischer said Monday the U.S. central
bank was worried the global market selloff could sap the strength of the
U.S. economy, suggesting the market's expectations of barely any interest
rate hikes this year could turn out to be right.
A Simplified Look At The Bailout Mechanism
The economy, markets, and monetary policy have an almost infinite number of
moving parts. However, a few charts can sum up the Fed's bailout process as
well as the adverse impact on inflation expectations.
All things being equal, low interest rates tend to have a stimulative effect
on the economy. Since monetary policy impacts the relative value of currencies,
lower rates also tend to equate to a weaker U.S. dollar. Corporate earnings
tend to benefit from a weaker U.S. dollar, which is pleasing to U.S. equity
investors.
Rates And The U.S. Dollar
There are also a wide variety of ETFs that fall into a "weak-dollar-friendly" category,
including oil (USO), energy (XLE), materials (XLB), and emerging markets (EEM).
While it is far from a direct correlation, the chart below shows stocks tend
to perform better when the Fed talks about keeping rates lower longer (dovish)
versus periods when the Fed hints at additional rate hikes (hawkish). The Fed's
tone, not surprisingly, is impacted significantly by movements in the stock
market.
Oil Prefers Lower Rates
Since many credit agreements in the oil patch are tied to the price of crude
oil, the recent waterfall plunge in oil prices started to have a negative impact
on the credit markets, especially junk bonds (JNK). Oil and wounded credit
were undoubtedly a part of the Fed's 26-day flip from "four hikes" to "barely
any interest rate hikes this year". Remember, oil falls into the weak-dollar-friendly
category.
Bailouts Are Not All Fun And Games
We can use the ratio of Treasury inflation-protected securities (TIP) to intermediate
Treasuries (IEF) as a way to monitor inflation expectations. With sharply rising
oil prices come rising inflation expectations. Notice the dotted blue horizontal
line shows the inflation expectation ratio has returned to the same level that
prompted Mr. Fischer to proclaim four rate hikes may be needed in 2016. It
is not likely the Fed allows inflation expectations to go unchecked forever.
As shown via the charts below, a hawkish Fed can dampen inflation expectations.
A hawkish Fed means a Fed that is talking about raising rates sooner and/or
more frequently, which impacts the U.S. dollar, stocks, and crude oil as well.
Core CPI Rose 2.2%
The benchmark for U.S. inflation is the consumer price index (CPI). With crude
oil tanking between mid-year 2014 and early 2016, CPI has benefited from a
muted energy component; other components have not been so tame. From CNBC:
The so-called core CPI, which strips out food and energy costs, inched
up 0.1%. That was smallest increase since August and followed a 0.3% increase
in February. In the 12 months through March 2016, the core CPI rose 2.2%
after gaining 2.3% in February. The Fed has a 2.0% inflation target.
Has Fed Waited To Hike Rates?
Anyone, including Stanley Fischer, who understands the lag between monetary
policy and inflation knows at some point the Fed will have to raise rates due
to rising inflation expectations. Fischer noted back in August 2015 the Fed "should
not wait until inflation is back to 2.0% to begin tightening". Crude oil has
rallied strongly in recent weeks, meaning it will no longer be a silent member
of CPI in 2016. The chart of the Federal Funds Rate below shows the Fed has
raised rates a mere 0.25% after keeping them at zero for several years.
Oil Was Not The Fed's Only Concern In Late January 2016
Clients and long-time followers know "the longer a market goes sideways, the
bigger the move we can expect" once the range breaks. The chart of crude oil
below provides a real world example. The left side of the chart shows the financial
crisis breakdown; the right side shows the more recent plunge.
Fed Received "We Need Help Calls"
Central banks often have dialogues with their global counterparts; sometimes
the dialogue takes the form of a call for help. From Reuters:
Confronted with a plunge in its stock markets last year, China's central
bank swiftly reached out to the U.S. Federal Reserve, asking it to share
its play book for dealing with Wall Street's "Black Monday" crash of 1987.
Compare the pre-plunge look of the crude oil chart above and the early 2016
look of the emerging markets chart below. It is easy to understand why many
experienced money managers had converted to a defensive stance in early 2016.
After the Fed talked about multiple hikes in 2016 (which tends to push the
U.S. dollar higher), the weak-dollar friendly EEM ETF broke down from a six-year
pattern of sideways action, which is a very, very vulnerable look as shown
via the recent crash in crude oil.
Like crude oil, emerging markets benefited from the Fed's about face on interest
rates between early and late January 2016. If the Fed decides to take a more
hawkish tone, it could throw a wet blanket over many of the current rallies
in cyclical/weak-dollar friendly ETFs.
Yellen To Double-Down On Wealth Effect?
With earnings declining for several quarters, it is possible Janet Yellen
has decided to double-down on the wealth-effect theory of economic stimulation.
From The
New York Times:
Ms. Yellen told the Economic Club of New York that the economy "had proven
remarkably resilient," and that the Fed expected better days ahead. She
said the Fed still intended to pursue a careful, patient course toward
higher interest rates as the economy improved. The cautious tone of her
remarks, however, suggested no rate increase was likely at the Fed's next
meeting, in April, shifting the eyes of Fed watchers to its subsequent
meeting in June. "I consider it appropriate for the committee to proceed
cautiously in adjusting policy," Ms. Yellen said. Stocks jumped and bond
yields fell in the moments after the publication of Ms. Yellen's remarks,
part of a now-familiar pattern in which markets celebrate signs of economic
softness and Fed restraint because that means interest rates will stay
lower for longer.
Fed Statement Next Week
The Fed may break their recent pattern of being dovish when stocks are on
the ropes and hawkish when stocks are hovering near their recent highs. However,
the public remarks made on Monday, April 18, by the President of the Boston
Fed remind us that it is unlikely the Fed can remain in stock/oil/emerging
market friendly mode indefinitely. From Reuters:
The Federal Reserve is set to hike interest rates more rapidly than investors
currently expect, a top Fed official said on Monday, again pushing back
on what he said was investors' too pessimistic view of the U.S. economy
and monetary policy. It was the second time in as many weeks that Boston
Fed President Eric Rosengren warned that futures markets, which see only
one modest rate hike in each of the next few years, are off the mark. He
said U.S. inflation was now "much closer" to the Fed's goal.
Fed Can't Postpone Hike Indefinitely
It is also possible the statements made in Jackson Hole last year, rising
inflation expectations, and the chart of interest rates below cause the Fed
to replace the dovish script with the hawkish script.
"Because monetary policy influences real activity with a substantial
lag, we should not wait until inflation is back to 2 percent to begin tightening."
Pop In CPI Could Spook Markets
We all know that hawkish Fed statements tend to put a drag on asset prices,
but what many may not be familiar with is the market's reaction to a well-above
expectations inflation reading, which would force the Fed to raise rates at
a faster than anticipated rate. The Fed is well aware of this possibility given
they have done next to nothing to prepare for such an event.
Putting The Rally In A Different Light
If the Fed shifts to the hawkish camp, as shown in this week's stock market
video, the current rally in risk assets may not be as impressive as it appears
at first blush, which speaks to hawkish vulnerabilities. Nothing would surprise
us given the recent actions of the Federal Reserve, including a decision to
double-down on the wealth effect.
