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Comfortably Numb: Fed Holds Rates Steadyby Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.November 4, 2009 Key points
In a unanimous decision by the Federal Open Market Committee (FOMC), the Federal Reserve confirmed its intention to maintain interest rates at an "exceptionally low" level for "an extended period," yet conceded that the US economy is improving. Whether the Fed was going to keep both of those key sets of words in its statement was top-of-mind for Fed-watchers. The benchmark overnight lending rate was maintained at a range of 0%-0.25%, where it has been since last December. The net is that its statement was on the "dovish" side as many expected more changes to the language reflecting both the improvement to the economy, but more importantly their exit strategy. Today's statement indicates the Fed isn't yet ready to follow some of its global central bank counterparts. The "big exit" … when and how? As some central banks around the world begin tapping on the monetary policy brakes and others consider their own timing, this week's Fed meeting—and the ones to come—are taking on significant meaning. There is a hawkish camp that's concerned about a Fed that stays dovish too long, risking either traditional price inflation or asset bubbles (more on that below). I sympathize with that concern. The Fed's dovish statement notwithstanding, the Fed might have to tap on the brakes sooner than the consensus might feel is appropriate. Frankly, it's not good news if we have an environment that justifies 0% interest rates as far as the eye can see. It's a bit odd that so many view this scenario as the better one versus one that justifies at least some normalization in rates. Benefits of normalization
Heading into today's Fed meeting, key members were perceived as setting the stage for eventual tightening of policy, leading many to assume a less dovish statement today. In late September, my friend and influential Fed governor Kevin Warsh wrote a well-read op-ed piece in The Wall Street Journal, in which he mentioned asset prices as a possible new target for the Fed: "Financial market developments bear especially careful watching. They may impart more forward-looking signs of growth and inflation prospects than arithmetic readings of stimulus-induced gross domestic product or lagged composite readings of inflation. For example, the level of asset prices and associated risk premiums, and gauging their trend and durability, will demand careful assessment." That was an extremely important paragraph and strongly suggested the Fed is keeping a close eye on financial markets and asset prices (versus just its traditional metrics of inflation and employment). Warsh went on further to hint of an earlier-than-expected withdrawal of some liquidity: "In this environment, market participants and policymakers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities." Fed Chairman Ben Bernanke himself recently gave support to those who believe the Fed has a closer eye on asset prices when he said, on October 19, that asset bubbles present a challenge that Asian governments will have to address in the future. That contrasts with his 2002 statement (and Alan Greenspan's view) that monetary policy can't be "directed finely enough to guide asset prices." Risk-taking vs. real economic growth PIMCO bond guru Bill Gross wrote in his November Investment Outlook: "The US and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up—then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them." The combined stimuli (monetary and fiscal) have done much more to stimulate risk-taking and paper transactions and less to stimulate the real economy, and the Fed may need to react to that phenomenon at some point. Even equities have become somewhat "commoditized" in terms of how they're traded. In today's fast-moving world, there appears to be less trading on company fundamentals, with more and more volume resulting from investors simply wanting exposure to the market—the popularity of exchange-traded funds (ETFs) is testament to that. Rate hikes (or prospects thereof) often cause indigestion I'll spend a bit of time in my next Market Snapshot webcast looking at the past two rate-hike cycles as they related to the stock market, inflation, unemployment and gross domestic product (GDP). In this report, I'll preview one set of charts from the upcoming video. You can see the stock market's tendency to have a little indigestion as rates are set to rise. The market began to have trouble several months before the first rate hike in 2004 (possibly due to the "heads-up" given by multiple language changes in the Fed's statement, as you can see documented in the chart below). In the prior era, stocks didn't run into trouble until the tightening actually started in 1994, possibly because they were less transparent. It's testament to the power of the Fed's words versus just its actions … and probably why the focus was so much on the Fed's statement today. Prior two rate-hike cycles as a guide  Click to enlarge  Click to enlarge Source: FactSet, Federal Reserve, ISI Group, and Standard & Poor's. Data pulled on November 4, 2009. Blue dots indicate subsequent rate hikes. Market correction … is concern about Fed policy to blame? Prior to the current contraction, we had two shallow corrections that were more in time than price. We've been suggesting we were overdue for one more in price than time. With major US stock market indexes having surged more than 60% (trough to recent peak) in seven short months, a period of digestion is not only necessary, but healthy. It might help ensure that monetary policy doesn't have to become restrictive before the economy suggests it's appropriate. The market's latest bout of weakness may be no more than a simple transition from "buy on the rumor" (of a possible economic recovery) to "sell on the news" (of an actual economic recovery). But prospects of less-hospitable monetary policy could have been at play, too. As you can see in the chart and accompanying table below, monetary policy has been highly stimulative and has naturally aided stock market gains. The table showing market performance deteriorating historically as policy was reined in may help explain some of the latest bout of weakness in equities. Time will tell whether the market prefers the easy monetary policy stance or is more fretful about its potential inflationary implications- asset or otherwise. From easy to tighter policy?  Click to enlarge
Source: Ned Davis Research, Inc. (NDR) as of September 30, 2009. The Real Monetary, Fiscal & Exchange Rate Policy Index is: Real M2 Money Supply (year-to-year change) plus Real Federal Expenditures (12-month total, year-to-year change) less Real Federal Receipts (12-month total, year-to-year change) less Real Broad Index of the Foreign Exchange Value of the Dollar (year-to-year change). For those looking ahead to an eventual rate hike, it brings up the impact on the dollar's funding role in the "carry trade." Thanks to extremely low rates in the United States, global investors are borrowing in dollars and then selling those dollars to invest in high-momentum areas like gold, commodities, emerging-market equities, etc. If the prospect of higher rates were to lift the dollar's value, this leveraged carry trade might have to be closed out—leading to a big snap-back rally in the dollar (as investors need to cover their dollar shorts) and negative reversals in the aforementioned areas. Pretty good GDP report It was natural to see elevated chatter about Fed policy as we approached this latest Fed meeting, especially given the better-than-expected GDP report out last week. Although not stellar, the report was hopeful in light of a modest rise in consumer spending (even after excluding the cash-for-clunkers effect), strong exports, rising federal spending (duh!), a slower drawdown in inventories, and even a lift from residential housing. And, although they remained detractors, both business investment and state/local government spending had only modest negative effects, after a string of much-weaker readings. One key change to the Fed's statement today reflected an improving spending environment: "Household spending seems to be stabilizing …" was changed to: "Household spending appears to be expanding …" A lot has been made of the weak credit environment; particularly pronounced given the unprecedented stimulus the Fed has pumped into the financial system. On this subject, there's much confusion and debate. On one side is the notion that the Fed has flooded the economy with too much liquidity and risks pumping helium into asset bubbles and inflation. On the other side is the notion that neither monetary nor fiscal stimulus has been sufficient to right the economic ship. Which is it? Indeed, loan growth is contracting and money supply growth is slowing. At the same time, cash assets in commercial banks and other lending institutions have exploded—"free reserves" are presently just under $1.2 trillion. Are banks really "hoarding" this capital or is there something else afoot? We've consistently held the view that it's the demand side of the equation that's causing more of a problem at this point than the supply side. Thanks to a record-breaking decline in corporate profitability, restrained pricing power and simple uncertainly, demand for credit is exceptionally weak. So far, what demand there is has been sufficiently sated by access to the debt markets (diminishing the importance of traditional banks). If businesses regain confidence in the economic recovery, they're well-positioned to take the lid off credit demand. Just as banks are now flush with reserves, so too is corporate America. In the second quarter, the 500 largest nonfinancial US firms held just less than $1 trillion in cash and short-term investments, or nearly 10% of their assets (on track to top 11% once the third-quarter earnings season is complete). That's up from less than 8% a year ago. That excess cash (representing lack of demand for credit/investment) has been a curse, but could eventually be an economic blessing—while also sending a signal to the Fed. Next steps for the Fed The Fed recently completed its Treasury purchase program and will end its mortgage-backed securities (MBS) purchase program next March. In its statement today, it said it would cut its agency purchases to $175 billion from $200 billion, but this is due to tight supply, not a policy shift. Concern is now elevated that, absent these purchases (even if the Fed keeps the short-rate pedal to the metal), long-term interest rates are set to rise—upsetting the nascent economic recovery. The hit to mortgage rates is of particular concern in light of recent better news on the housing front. Estimating the impact of the Fed's withdrawal of liquidity on Treasury and/or mortgage rates is not an easy task. However, historically, Treasury yields have led the Fed's tightening moves by about four months, on average, for the past three tightening cycles. To date, yields haven't exactly followed the playbook of quantitative easing. Even though Treasury purchases have waned significantly, yields on the 10-year Treasury have fallen, too. This leads us to the conclusion that we've moved out of an environment where the Fed's purchases are key to one where private-sector credit demand will be the key force behind longer-term rates. I would expect the Fed to be more willing to pull the trigger if we saw an acceleration in private sector credit demand. They also more clearly spelled out other drivers to keep an eye on. In the Fed's statement today, it expanded on the rationale for keeping rates so low—namely the trio of "low rates of resource utilization (unemployment rate), subdued inflation trends and stable inflation expectations." But asset prices may also be on the Fed's radar and could unleash an era for the Fed that has no precedents. Important Disclosures The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve. (1109-11096) Return to Top |
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