The End Of The Fed's "Interest Rate Magic Show" Looms

If it feels like you are reading last year’s business stories in today's paper, there is a simple reason. The Federal Reserve's Open Markets Committee (FOMC) meeting date [15] is approaching, and in a replay of what we have seen ahead of previous meetings, we are being told that this is the one where the Fed will lower the boom on stock markets, by raising interest rates. While this navel gazing may keep market oracles, Fed watchers and CNBC pundits occupied, I think that the Fed’s role in setting interest rates is vastly overstated, and that this fiction is maintained because it is convenient both for the Fed and for the rest of us. I think that there are multiple myths about the Fed’s powers that have taken hold of our collective consciousness, and led us into an investing netherworld. So at the risk of provoking the wrath of Fed watchers everywhere, and repeating what I have said in earlier posts, here are my top four myths about central banks.
 

Myth: The Federal Reserve (or the Central Bank of whichever country you are in) sets interest rates, short term as well as long term. In my last post on this topic [16], I mentioned my tour of the Federal Reserve Building, with my wife and children, and how sorely tempted I was to ask the tour guide whether I could see the interest rate room, the one where Janet Yellen sits, with levers that she can move up or down to change our mortgage rates, the rate at which companies borrow from banks and the market and the rates on US treasuries.

 

Reality: There is only one rate that the Federal Reserve sets, and it is the Fed Funds rate. It is the rate at which banks trade funds, that they hold at the Federal Reserve, with each other. Needless to say, not only is this an overnight rate, but it is of little relevance to most of us who don't have access to the Fed windows. While there is a tenuous link of Fed Funds rate to short term market interest rates,  that link becomes much weaker when we look at long term rates and their derivatives.

 

Why preserve the myth: Giving the Fed the power to set interest rates gives us all a false sense of control over our economic destinies. Thus, if rates are high, we assume that the Fed can lower them by edict and if rates are too low, it can raise it by dictate. If only..

 

Myth: Interest rates are at historic lows not just in the United States but in much of the developed world, and it is central banking policy that has kept them there, through a policy of quantitative easing The myth acquires additional sheen when accompanied by acronyms such as QE1 and QE2, which bring ocean liners to my mind and a nagging fear that the next Fed move will be titled the Titanic!

 

Reality: The Fed has had a bond-buying program that is unprecedented and large, but only relative to the Fed's own history. Relative to the size of the US treasury bond market (about $500 billion a day in 2014), the Fed bond-buying (about $60-$85 billion a month) is modest and unlikely to have the influence on interest rates that is attributed to it. So, what has kept rates low? At the risk of rehashing a graph that I have used multiple times, it is far simpler and more fundamental, and it lies in the Fisher equation, which decomposes the nominal interest rate into its expected inflation and real interest rate components:

If you make the assumption that in the long term, the real interest rate in an economy converges on real growth rate, you have an equation for what I call an intrinsic risk free rate.  In the graph below, I graph out the actual US 10-year treasury bond rate against this intrinsic risk free rate and you can make your own judgment on why rates have been low for the last five years.'

To me, the answer seems self evident. Interest rates in the US (and Europe) have been low because inflation has been non-existent and real growth has been anemic, and it is my guess that rates would have been low, with or without the Fed’s exertions. In fact, the cumulative effect of the Fed's exertions can be measured as the difference between the intrinsic risk free rate and the US treasury bond rate, and during the entire quantitative easing period of 2008-2014, it amounted to about 0.13%. It is true that the jump in US GDP in the most recent quarter  has widened the difference between the treasury bond rate and the intrinsic interest rate, but it remains to be seen whether this increase is a precursor to more healthy growth in the future, or just an one-quarter aberration.

Why preserve the myth: I think it is much more comforting for developed market investors to think of low interest rates as an unmitigated good, pushing up stock and bond prices, rather than as a depressing signal of future growth and low inflation (perhaps even deflation) in much of the developed world. That problem will not be fixed by Fed meetings and is symptomatic of shifts in global economic power and a re-apportioning of the world economic pie.

 

 

Myth: Stock prices are high today because interest rates are at historic lows. If interest rates revert back to normal levels, stock prices will collapse.

 

Reality: Low interest rates have been a mixed blessing for stocks. The low rates, by themselves, make stocks more attractive relative to the alternative of investing in bonds. But if the low rates are symptomatic of low inflation and low real growth, they do have effects on the cash flows that can partially or completely offset the effect of low rates. One way to decompose the effects is to compute forward-looking expected returns on stocks, given stock prices today and expected cash flows from dividends and buybacks in the future to see how much of the stock price effect is fueled by interest rates and how much by cash flow changes. If this bull market has been entirely or mostly driven by the drop in interest rates, the expected return on stocks should have declined in line with the drop in interest rates. In my most recent update on this number at close of trading on August 31, 2015, I estimated an expected return of 8.50%, almost unchanged from the level in 2009 and higher than the expected return in 2007. 

At least based on my estimates, the primary driver of stock prices has been the extraordinary fountain of cash that companies have been able to return in the last few years, combined with a capacity to grow earnings over the same period. By the same token, if you are concerned about cash flows, it should be with the sustainability of these cash flows, for two reasons. The first is that earnings will be under pressure, given the strength of the dollar and the weakness in China, and this is starting to show up already, with 2015 earnings about 5-10% below 2014 levels.  The second is that companies will not be able to keep returning as much as they are in cash flows; in 2015, the cash returned to stockholders stood at 91% of earnings, a number well above historic norms. In the table below, I check to see how much the index, which was at 1951.13 at the close of trading on September 3, would be affected by an increase in interest rates (increasing the US 10-year T.Bond rate from the 2.27% on September 3, to 5%) as contrasted with a drop in cash flows (with a maximum drop of 25%, coming from a combination of earnings decline and reduced cash payout): If you hold cash flows constant, an increase in interest rates has a relatively small effect on stock prices, with stock prices dropping 8.76%, even if the US T.Bond rate rises to 5%.  In contrast, if cash flows drop, the index drops proportionately, even if interest rates remain unchanged. You are welcome to make your own "bad news" assumptions and check out the effect on value in this spreadsheet [19].

 

[20]

 

Why preserve the myth: For perpetual bears, wrong time and again in the last five years about stocks, the Fed (and low interest rates) have become a convenient bogeyman for why their market bets have gone wrong. If only the Fed had behaved sensibly and if only interest rates were at normal levels (though normal is theirs to define), they bemoan, their market timing forecasts would have been vindicated. 

 

 

Myth: The biggest danger to the Fed is that, if it reverses its policy of zero interest rates and stops its bond buying, stock and bond markets will drop dramatically.

 

Reality: While no central bank wants to be blamed for a market meltdown, the bigger danger, in my view, is that the Fed does what it has been promising to for so long, and nothing happens. That is a good thing, you might say, and while I agree with you in the short term, the long-term consequences for Fed credibility are damaging and here is why. The best analogy that I can offer for the Fed and its role on interest rates is the story of Chanticleer [21], a rooster that is the strutting master of the barnyard that he lives in, revered by the other farm animals because he is the one who causes the sun to rise every morning with his crowing (or so they think). In the story, Chanticleer’s hubris leads him to abandon his post one morning, and when the sun comes up anyway, the rooster loses his exalted standing. Given the build up we have had over the last few years to the momentous decision to change interest rate policy, think of how much our perceptions of Fed power will change, if stock and bond markets respond with yawns to an interest rate policy shift.

 

Why we hold on to the myth: If you buy into the first three myths, this one follows. After all, if you believe that the Fed sets interest rates, that it has deliberately kept interest rates low for the last five years and that stock prices are high because interest rates are low, you should fear a change in that policy. Coupled with China, you have the excuses for your underperformance this year, thus absolving yourself of all responsibility for your choices. How convenient?