The 'Broken' Fed Model In 3 Simple Charts

Tyler Durden's picture

One of the most commonly cited 'bullish' memes for stocks is the so-called Fed Model (or Equity Risk Premium) or more simply - the fact that earnings yields are not catching up to Treasury yields (i.e. why put your money in government bonds at such low rates when there is smorgasbord of yummy equities with 'attractive' dividend yields). There are three key problems with this perspective: 1) No concept of 'risk' is imbibed in this return-based differential (as we have discussed before here and here); 2) Longer-term historical context is critical (as we discussed here - must read); and most importantly 3) Financial Repression breaks the 'Fed Model'. As Barclays shows in the following three charts (and we pointed out recently) normalization of the equity risk premium will not occur until Financial Repression ends.


The Fed Model has broken - what are asset allocators to do? This occurred two other times in history...


As it seems in reality, the perceived risk differential between bonds and stocks is indeed critical in confirming the Fed Model... and that differential has become majorly disconnected since the crisis began (*and rightly so)...


Critically, just as we saw with the Great Depression, once the Fed removed itself (or reduced itself) by ending its then QE program of financial repression, then markets can clear and signal capital to move into not incorrectly-attractive investments...


So the next time someone throws the "So what you gonna do? Put your money in Treasuries at 2% yields?" line at you; kindly stroke your chin (reflectively), pause (philosophically), and tell them that until the Fed takes its boot off the interest-rate neck of the nation and stops buying every bond in sight, the risk-reward favors non-equities - and as any good entrepreneur putting their hard-earned capital to work knows 'a fed-induced period of mal-investment' can only end one way - and if you are patient, there will be plenty of 'opportunities' when that end begins.


Charts: Barclays

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ACP's picture

Dont Fight the Fed...

..until after the election.

EnslavethechildrenforBen's picture

When was the Fed Model NOT broken?

AldousHuxley's picture

when every dumbass was flipping homes and taking home equity loans out to buy an Escalade and banksters getting million dollar bonuses and public pensions set to 8% perpetual growth and wage slaves voting for republicans to spend billions on wars because they think they made it rich.


now, everyone is all up in Fed's business. But Fed, like Ron Paul is at least consistent.

The Monkey's picture

This analysis misses an important feature of ZIRP, that it can't be compared to any other era in US history. So, one might consider Japan, where equity prices simply been a proxy for the economic cycle for the past 22 years and valuation multiples have been compressed to align with lethargic growth.

philipat's picture

And I don't believe that The Fed ever used the "Fed" model. It was a comment made by Greenspan at a Press conference once and............................................Greenspan? I rest my case.

NotApplicable's picture


When The Bernank is "100% certain?"

gwar5's picture

FED is not broken, it was born that way.


buzzsaw99's picture

the fed wants you to buy maggot IPOs because they hate you

helping_friendly_book's picture

I am enjoying this. My shares of SPXU have gone up 22% in one month. 

Go BB, Go!

Risk off bitchz!

S&P 888, here we come.

Orly's picture

You should seriously consider taking gains here and leave it alone for a while.  Say, March-ish.


helping_friendly_book's picture

I am waiting for the grand awakening when the market takes a real shit. I've got my sell order in at $150/share.

FRBNY has said, repeatedly, they can do nothing more.

Congress will spite Obama for another two years until we get rid of Eric Cantor. Then, and only then, will I go long.

As long as that fartlicking cocksucker is the majority house leader I will stay short.

Orly's picture


Okay.  All I said was take your 22% and put some popcorn in the microwave.


helping_friendly_book's picture

I appreciate your sentiment but, I can assure you, I don't have my life's savings riding on it. 

I will, therefore, let it ride and trust my initial intuition althought I might be a year early ; as usual.

It is hard to make money when I can't gauge the dimensionality. Fractal that is.

If you know a good Mandlebrot disciple, please, let me know.

I don't seem to have the gift!  

ProtectiveFather's picture

Of all that is wrong with this country, Eric Cantor is what gets your panties in a wad? Eric Cantor is your market indicator? Did he kill your puppy or something?

knowless's picture

This just sounds like a postapple i told you so, whether or not bonds hold redemption value at par.. Do they even? Muddled and bizarre.

fonzannoon's picture

Orly nice freakin call on the Yen/USD

I am curious, what can they possibly put out there to the msm that can not only stop the bleeding but reverse this market and send it higher? I spend time trying to think like these sick bastards....all I can come up with is this...they start dropping some rumors that both parties have agreed in principle to a massive grand bargain. The MSM marches out execs and pundits to praise this agreement. The market quickly covers and starts going higher, maybe for a month or so. Then the details of the plan that never was start falling apart. Thats all I can come up with for a market pop.


disabledvet's picture

are you asking "what can Exxon Mobil pull out of the ground that Japan could possibly want"? cuz that is a question i understand the answer to. If you are asking "what can Uncle Sam print that Japan can't already print" THEN i'm not so sure..."and one look at dollar yen says a whole lot of other people agree with that as a question too." specificity matters in these debates. you will hear NONE of that with the Tylers Durden. PANGLOSSIAN bullshit "unless you agree to the oldest Ponzi of them all...that for gold."

Orly's picture

Well, apparently everything revolves around the Euro/US Dollar cross.  If it is not equities that were driving the risk before, next will be the risk currency pairs (EURUSD, AUDUSD...) driving the equities higher.  It is like they are taking this opportunity to switch drivers.

You probably won't get a lot of huge announcements out of Europe now, as they will try to keep their affairs on the DL (down-low...) but there will be a relentless campaign to drive the EURUSD pair back above 1.28, with a nice buffer.  I have the top of the zone around 1.295 just to give them a little breathing room.  For some reason, everything in global stability relies on the EURUSD staying above 1.28.  I can't fathom why exactly.

There is no telling how long it will take to move the risk pairs up in tandem with stocks but they will key off of each other.  Look for the AUDUSD to really ramp steadily over the next several weeks after this sell-off.  The tie to equities (risk...) really seemed to catch them off-guard and I don't think they'll be so lenient next time until they are really ready for risk-off, so there will be a coordinated effort, much like throughout 2006 when equities didn't have a single down day all year.  They will try to follow the same model.

In essence and in answer to your query, this move up will be nice and quiet, nice and steady while we are distracted with turkeys, Father Christmas and the Super Bowl.  (Go Texans!)

As for my call in USDJPY, yes, I did make that call.  Unfortunately, I was waiting for the consolidation to finish before I got back in and by that time it was too late to catch the second leg up, which should not have occurred without some sort of retracement (more HFT, I am afraid...).  Now, I am short (scalping...), as there is no way this move makes any sense.  It was certainly driven by algos running the Noda announcement that he would dissolve government and have a vote this December.  Little do the algos know that Abe, who promises printing until the cows come home, will not win the general election; Noda will, much to the shock and chagrin of negative-yield pump-and-dumpers who are going to get the shock of their lives.  They've already overdone it and now I'll catch it on the retrace to something more reasonable.

But, thank you for noticing me.


fonzannoon's picture

For whatever it is worth, here is my theory on the Euro/USD. I can't speak for anyone in Europe but your average Joe in the US seems to only know how to measure the USD against the Euro. I will trust others in Europe to tell me if the average European only really watches the Euro vs the USD. Maybe they watch it against the Pound too, but they are pretty much linked now right?

Anyway, I think that the Fed and the ECB have a deal to keep it trading in a range. maybe 1.27 to 1.31. Something like that. I know that no average Joe knows nor cares whether the USD is falling against the CAD/AUD etc etc. So through the eyes of the market, as the euro heads towards 1.31 stocks rise. Then it falls back to 1.27 stocks fall. But I would not be surprised if both currencies fall against everything else except each other as time goes on. As long as those two currencies stay close to each other people will hardly notice what else is going on. I know you and Yen Cross do a lot more due dilligence, it's not my area, but thats how I see it.

Orly's picture

Well, you're right, of course, but the question is, "Why?"

The only reason I can think of was told in this exchange between Rep. Alan Grayson and the Chairman of the Federal Reserve Board, Dr. Ben Bernanke, at the very beginning of the financial crisis:


AG: So what happened to the half-trillion dollars, Mr. Chairman?

BB: I don't know.  Sent to Europe.

AG: To Europe?

BB: Yeah.  To banks; European banks.

AG: Which European banks?

BB:  Errmm, I'm not sure.  I can get my people on that question.

AG: Gee, wouldja?


So, basically, they traded a half-trillion US Dollars for either Pounds or Euros.  But it's not like it's their money.  It was a "swap."  So we took Euros and Pounds (plunging at the time...) for USD in order to give them liquid dollars to work with.  (And so you see, when it really comes down in a pinch, everyone wants USD.  That's why there is no Treasury bubble and there will never be hyperinflation in the US...)

The thing is, if the Euro and the Pound drop below a certain level (~1.28 on the Euro...), then they start losing money and will have to swap back the money at a loss, which would obviously crush any semblance of European stability.  That's the only thing I can think of.

Either way, this does not end well.


fonzannoon's picture

"in a pinch, everyone wants USD"

I've seen that Grayson vid before. It's amazing, I completely agree. IMO the dow could drop 5k and people would scream that that Bernanke is dead but as long as that money flows into treasuries it does not mean anything. The game goes on.

Orly's picture

But how are you, fonz?  Everything getting back to normal yet?  Seems the entire northeast got their eyes opened to this disaster and maybe won't be so callous next time it happens to "someone eltse"?

fonzannoon's picture

I am fine. Appreciate all the good sentiment I got on here. I really do. Things are back to normal. I swear I was never a glass half empty guy. But to answer your question....I don't think the Northeast is callous so much as it is oblivious. More importantly, for us to try to lump the Northeast in as one group is a mistake. I can tell you that I keep the company of some people that are damned good people. Productive, compassionate and resourceful people. The problem up here is the system has been rigged from both ends. The big money wall street crowd, and the union federal employee crowd. Each has bent and broken every law and regulation and totally tilted everything in their favor. The people in between just get crushed by this, and can't figure out why.

But they are soooo busy updating facebook and trying to get to the mall that they don't give a shit what happens here, or anywhere else. You think someone who never lost power in a wealthy neighborhood here gives a shit about a poor neighborhood that got wiped out? Or vice versa? The "Northeast" is just a bunch of individuals. Unless the problem falls in their lap they don't want to hear about it. Whether it happens in New Orleans or one town over.

OpenThePodBayDoorHAL's picture

they know they need to manage the race to debase, it's a race where the loser is the winner after all. everybody beggaring their neighbor until there is no more neighbor.

WhiteNight123129's picture

You have to factor positive versus negative yields in real terms, because those charts miss a key component. Positive versus negative real yield and action on commodities.


Rocket surgeon's picture

Back to the original post with 3 simple charts and 3 key problems. All good points, but they don't explain a trend that was visible for 30 years. And yes, one can argue that the correlation or cointegration was not perfect in these decades. But the explanation of why the trend was there in the first place is still very weak. A fairly recent paper states that the fed model is misspecified and that the S&P 500 earnings yield is not in equilibrium with the government bond yield but with the average after-tax interest rate on corporate bonds. The reason? Company managements manipulate capital structure such that earnings-per-share are maximized. The paper ( explains why the equilibrium emerged in 1982: because before that time share repurchases were more or less prohibited. It explains why the equilibrium seems to have disappeared over the last 5 years or so: because the gov. bond yield diverged strongly from the corporate bond yields, and we were all looking at the wrong parameters. Here an interesting graph: