Via Mike O'Rourke of Jones Trading,
Sometimes you see something that is from a credible source and you are so dumbfounded you don’t know what to think. Late in the trading day, the WSJ’s Jon Hilsenrath published a story about the approach the Fed will take coming out of next week’s FOMC meeting. The first few sentences say it all. “Federal Reserve officials have been trying to convince investors for weeks not to overreact when the central bank starts pulling back on its $85 billion-per-month bond-buying program. An adjustment in the program won’t mean that it will end all at once, officials say, and even more importantly it won’t mean that the Fed is anywhere near raising short-term interest rates.” The program end all at once? (It is more like will it ever end?) Anywhere near raising short term interest rates? Really, if there is anyone out there who is legitimately worried about a Fed rate hike in the near term, please let us know (we are serious).
First, if the Fed believes the market is worried about a rate hike, it would be downright terrifying how out of touch the Central Bank. Second, the fact that the equity market rallied 50 basis points and the 10 year yield dropped 5 basis points in reaction to a premise that makes no sense to most people making investing decisions adds additional concern. For sanity’s sake, we will chalk it up to this being a shoot first business and the story broke 20 minutes before the close.
Hilsenrath highlighted the number of short term fixed income markets pricing a tighter Fed Funds rate in 18 months and explained that this distresses the Fed. As it stands now, the Fed controls fixed income spot markets. At the short end, it controls the Fed Funds rate and at the long end, it is buying Treasuries. The Fed is now upset because markets are determining the future. Rates it doesn’t control are pricing in the future in a way that is not aligned with the Fed’s view.
When there is a housing bubble or an equity bubble, the Fed will be the first to say, “who are we to disagree with a market comprised of participants far more informed than the Central Bank?” Such statements are the Fed’s way of avoiding tough decisions because if there is anything the past 13 years have proven, it is that markets often misprice assets. It is just another sign of the Fed’s intellectually inconsistent practices that result in policy by whim. The FOMC has a remarkable degree of hubris to expect markets to conform to its policy promises 18 months out, especially when it has given little clue as to how policy over the next 6 months will look and Chairman is expected to retire in 7 months.
Hilsenrath cited three possible explanations for the move in short rates.
1. Money markets are out of whack for technical reasons.
2. The market is pricing in a stronger economy, which it in turn expects to prompt Fed rate increases.
3. Investors are starting to doubt the Fed’s commitment to keep short-term rates down.
The Federal Reserve is actively manipulating markets more than ever, but it could be technical reasons? The market pricing in a stronger economy is called the Fed being “behind the curve.” That happens continually and is not new. Ironically, investors doubting the Fed’s commitment to keep rates down would be the opposite of being behind the curve. There is almost nobody involved in these financial markets who doubts the Fed’s commitment to keep short term rates low. If anything, it is the market questions the Fed’s ability.
Here is our explanation for the move in short rates - the loss of confidence in the Central Bank and its policy making process. The Fed’s balance sheet and Quantitative Easing program has become a Frankenstein monster over which the Central Bank is losing control. QE1 started during a crisis and was either incredibly successful or well-timed. It is often forgotten that the S&P 500 dropped another 22% in the first 3 months of QE1. QE1 had an Exit Strategy, a plan, a time frame and a reason. QE3 has no Exit Strategy, no plan, time frame, no expected level of job creation and no known end. As such, forecasting is nearly impossible in a policy by whim environment, especially when the key decision maker is likely to leave.