The Fed and the Markets (Part 3)

Thursday, November 30, 2017

By: Christopher P. Cline, CEO

We’re looking at the effect of the Fed’s actions on the stock and bond markets. In the first installment, we looked at how the Fed promotes economic growth and price stability. In the second, we examined the way stocks and bonds are valued, and how economic factors (including those triggered by the Fed) move those values. In this final segment, we’re going to see how the Fed’s actions actually have affected the markets over the past year.

But first, a word of apology: it’s been three months since the last installment. This reflects the ever-changing economic conditions around the world, changes that have confounded traditional thinking. This final installment will attempt to explain some of those changes.

Brief Recap

Before diving into how strange things have been, let’s summarize how things ought to work in a perfect economic world. A government can affect markets in two ways. First, the government itself can direct “fiscal policy,” which is another way of saying raising or lowering taxes and increasing or decreasing infrastructure spending. We saw the effects of this late last year with the “Trump Bump:” stock market prices rose sharply on the President’s mere promise to cut taxes and increase spending.

Second, the government’s central bank (which in the U.S. is the Federal Reserve, or the “Fed”) can make changes to “monetary policy.” This also has two components: raising or lowering the short-term interest rates banks charge each other (and thereby changing interest rates across the economy) or through making more money.

Since the Great Recession, the Fed has done both. It has kept interest rates low, and it has created new money through “quantitative easing,” a program under which the Fed bought fixed income assets like bonds from banks by issuing new money.

Keeping interest rates low should stimulate the economy by making corporate borrowing more attractive (encouraging expansion) and by nudging investors toward stocks and away from fixed income as they seek higher returns.

Candidly, no one quite knows how quantitative easing (or “QE”) works, or how well it has worked. The general idea is that QE stimulates the economy by encouraging banks to make more loans: banks take the new money and buy assets to replace the ones they have sold to the central bank. That raises stock prices, lowers interest rates and boosts investment.

The best signs that an economy is picking up are that stock prices go up as bond prices go down, unemployment rates fall as companies do more hiring and inflation rates creep up. It is this last sign that the Fed traditionally focused on as an indicator that it’s time to raise rates.

Once the inflation rate goes beyond an acceptable level, the Fed then responds by raising the short term rate, and by selling the assets it bought through QE. This process should restrict the flow of money, both by taking some out of circulation and by making lending more expensive. This, in turn, should slow economic growth and bring the inflation rate back to an acceptable level.

Or so the theory used to go.

Where is the Fed at Now?

The Fed anticipated raising rates three times in 2017, as it saw economic growth and inflation rising. The Fed’s inflation rate target for continuing to raise rates is 2%. However, after raising rates twice so far this year, it encountered a dilemma: on the one hand, the inflation rate did not stay above 2% (which means the Fed SHOULDN’T continue to raise the interest rate), but on the other hand, the prices of both stocks and bonds have risen and the dollar has stayed relative weak (which means the Fed SHOULD raise the rate).

The troubling aspect, for the Fed, is that the economy is growing but inflation isn’t. For example, the U.S. economy grew at an annualized rate of 3% but inflation only grew by 1.7%, below the target rate of 2% which triggers Fed actions.

At this point, the Fed is still considering a final rate raise in December and perhaps three more in 2018. It also is considering lowering its QE balance sheet slowly, not by selling the assets it previously bought, but simply by allowing the bonds it holds to mature and not replacing them by buying new ones.

What Does it Mean?

The behavior of the markets this year has shown the limits of the Fed’s ability to affect them. In August, the U.S. economy posted its record-setting 82nd month of job creation, reducing the unemployment rate to the lowest point in 16 years. However, economic growth is a weak 2%.

Stock market values are at near-record highs by some measures (under the cyclically adjusted price/earnings measure, values are as inflated as they were on Black Tuesday in 1929). Yet most analysts seem unfazed, because economic growth is still slow and steady, the Fed’s interest rate increases are small and the dollar is weakened.

This is not necessarily bad news. Growth in the U.S. gross domestic product (“GDP”), a broad measure of domestically produced goods and services, has averaged 2.1% per year since the Great Recession in 2009, which is lower than the growth experienced after past recessions. This also seems to mean, however, that this more plodding growth could continue longer, reducing the possibility of another recession in the near term.

Such slow growth, however, leaves the Fed in a quandary. It would like to continue to wind down stimulus and raise rates, but it doesn’t have the economic data to back it up. Back on June 27, the Wall Street Journal observed that the yield on the 10-year Treasury Bond had dropped to its lowest level for the year (meaning bond prices went up) even though the Fed had raised rates three times in the previous seven months. In other words, its efforts through most of 2017 haven’t been especially effective.

This is not to say that the Fed’s actions have no effect. Technology companies and emerging markets are particularly sensitive to U.S. interest rates and are watching the Fed’s moves closely. Tech stocks have been especially popular in this lower economic growth environment, partly because they hold out the promise of future profits. Such profits are worth more when interest rates are low. Further, tech stocks in Taiwan and South Korea make up a significant portion of the MSCI Emerging Markets Index, which means that index also is sensitive to the Fed’s raising of rates.

In addition, banks should benefit as the Fed shrinks its asset base. First, as the Fed lets bonds mature, basically taking that value out of circulation, the banks have less cash on their balance sheets. That means that they have to go out and buy very safe bonds and debt obligations to meet their capital funding requirements. This generates a better return to them than the cash that they were holding did. Second, less money in circulation should raise lending rates.

Where are the Fed and the Economy Going?

On November 2, President Trump settled an ongoing question when he nominated Jerome Powell to succeed Janet Yellin as Fed chairman. In doing so, President Trump seems to be supporting policy continuity over a more aggressive position with regard to rates. Mr. Powell in his five years at the Fed has been an ally of Ms. Yellen’s. If that position remains unchanged, Mr. Powell will probably continue slowly allowing the Fed’s balance sheet to shrink (unwinding its QE efforts) and supporting a slow raising of interest rates. The one change that Mr. Powell might make is to reduce the amount of regulation that the Fed imposes on financial institutions.

This leadership change comes at a time when the economy seems to be heating up and the Fed’s efforts are bearing fruit. The Wall Street Journal on October 25 noted that the yield on 10-year Treasury bonds rose above 2.4% for the first time in five months. (Always remember that when bond yields are increasing, in means that their prices are decreasing). This may indicate a turning point in bond prices. This is in contrast to five months ago, when emerging market bonds kept rising in value despite the expected European Central Bank’s efforts to reduce stimulus (it should have gone the other way).

Three days later, the Journal observed that the U.S. economy posted its best six-month stretch of growth in the past three years, even with several natural disasters devastating significant portions of the country.

What Does this Mean for Me?

Now that we’ve discussed how the Fed works, the effects its efforts should have on stock and bond market prices, and some of the effects that it has ACTUALLY had, the next logical question is whether the Fed’s actions have impacted individual portfolios, and whether they will have impacts in the future. To begin with, there’s no clear answer: markets have behaved strangely in response to QE and interest rate raises (when they have reacted at all). Prices of all assets have increased recently, confounding traditional expectations, yet inflation has remained puzzlingly low.

Yet there undoubtedly have been some effects. Quantitative easing has provided some stability for markets post-Crisis, without which world economies (and their underlying investment markets) would have been even more unstable.

Stock prices seem unrealistically overpriced, yet growth has been slow and steady rather than overheated. Bond prices have until recently continued to rise even though traditional economic principles would say they shouldn’t have. It appears that the Republican Congress and administration is serious about tax reform, and early signs are that such reform will stimulate the economy even further. And through it all, the Fed is maintaining a steady course of small and regular rate rises and QE unwinding.

All of which means that, as always, markets are unpredictable and therefore market timing is a bad idea. Stocks probably have a little more room to grow before a pullback, and bonds may finally be responding to interest rate increases. So, in the end, the answer is the same boring one it’s always been: stay the course, don’t react to the current economic environment, don’t bet on trends, government actions or anyone’s “instincts.” Let the markets do what they do best: bounce around a lot in the short run, and make you wealthier in the long run.


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