Submitted by Nicholas Colas of Convergex
Three Fed Thoughts, One Conclusion
We learned one thing yesterday: the U.S. Federal Reserve is in the same position as the rest of us when it comes to forecasting the future path of economic growth. Nobody really “Knows” anything right now. From that touchstone observation, we add two additional points. First, if you think the Fed is going to reverse course any time soon, be aware that neither Fed Funds Futures nor the 2 Year Treasury agree with you. Both discount a slow but perceptible increase in rates this year. Second, it pays to think a little more long term than just 2016. For example, consider that Chair Yellen has exactly 2 years left in that role before the next U.S. President can opt for someone else. What does she want her legacy to be? Not, I think, the Chair that failed to get (and keep) Fed Funds off the zero lower bound.
There is an old adage in economic circles that “Stock market indexes have predicted nine of the last five recessions”. The author of that statement is none other than Nobel Prize winner Paul Samuelson, who concluded the observation with “And its mistakes were beauties”. Fair enough – equity markets are notoriously fickle. But market watchers would be fair in asking, “Fine… But how many recessions have “Blue chip” economists called correctly?”
It is in that philosophical cage match that investors and the Federal Reserve find themselves just now. Global equity market volatility combined with ever-lower crude oil prices are like a traffic signal turning from yellow to red. And red is also pretty much all you see on the screen. The economics-minded stewards at the Fed see an entirely different picture: low notional unemployment, the dry powder for consumer spending in the form of lower oil prices, and easy monetary policy around the world. For them, the light is turning green.
But one side will be right, and one side will be wrong. The dichotomy is too stark for any other conclusion.
Looking through the Fed’s statement today, I had three observations about how the central bank is weighing these facts versus how capital markets perceive them.
Point #1: The Federal Reserve’s cautious stance shows they don’t know any more than capital markets do about the current trajectory of global economic growth. They see the volatility in equity markets and oil’s slippery slope but are keenly aware that markets are fickle. Just think back to the August 2015 bout of volatility and how the Fed seemed to put off a September rate increase because of it. Whether that was optics or reality, it set a precedent that global equity market volatility could alter Fed policy. Look for the Fed to wait on the real economic data that surrounds its dual employment and inflation mandate before it fundamentally changes course.
There’s one exception to that observation, at least by historical Fed policy standards: a market crash caused by external events. A 1987-style meltdown isn’t enough since the central bank playbook there is to simply ensure the system has the liquidity it needs. If there were a geopolitical shock, however, that’s a different page in the playbook. Barring such an event, however, the Fed is going to take its time in 2016. An S&P 500 that grinds lower by another 5-10% isn’t likely going to change that.
Point #2: While plenty of market watchers are calling for a return to zero interest rates and maybe more quantitative easing, some tell-tale capital markets disagree those events are in the cards. Fed Funds Futures peg the chance of a July rate increase at 50% and put the chance of higher rates by year-end at 68%. Two year Treasuries – the hair trigger of the yield curve for changes in Fed policy – yield 83 basis points. That’s down from over 100 basis points late last year but still higher than September 2015 when the market was sure the Fed was going to increase rates. The point here is that these markets are not forecasting a return to zero interest rates. Not even close.
For the sake of completeness, there are two markets that have their doubts. Gold prices are up from their 2015 lows of $1,050/troy ounce to $1,125 currently. Given that the yellow metal has been in a vicious bear market since 2011, that is a notable reversal of fortune and could be the canary in the coalmine chirping a warning about further fiat currency debasement. The other market worth a mention is the 10-year U.S. Treasury note. At a 2.0% yield, it signals a vote of no confidence in the Fed’s hope that inflation will return to desired levels any time soon.
Point #3: Fed Chair Janet Yellen has exactly 2 years left in that position before the next President has a chance to consider reappointing her or choosing a new person to fill the slot. Think of the Federal Reserve as either a blue chip public company or major branch of the U.S. government. In both cases, the people that run them give serious thought to their legacy – what they did to shape the organization’s goals and what specific accomplishment they achieved.
Through that lens, the conversation about Fed policy in 2016 takes on a different hue. In retrospect, every Fed Chair has their emblematic “Achievement”: Paul Volcker (tamed inflation), Alan Greenspan (the 90s expansion), Ben Bernanke (saved the financial system). For Janet Yellen, her prospective accomplishment must be “Got things back to normal”. That means getting interest rates far away from the zero lower bound if at all possible. If for this reason, and no other, the Fed is going to raise rates in 2016 barring a shock to the system.
The conclusion here: you dance with who you brung, and this Fed is our date to the prom. They don’t have any greater level of clarity about how this year is going to shape up than the marginal investor setting equity prices or an oil trader looking for direction in that market. This is patently different from the period from 2008 – 2015, when the Fed was clear about its perspective and knew exactly which policy levers to pull. Perhaps they were wrong, but they were never in doubt.
Now, there’s enough doubt for everyone: markets, central banks, consumers, governments. Everyone. The best thing we can say about that: if markets accept that the Fed is no better informed than they are, maybe investors will devote more time to stock fundamentals and intrinsic value analysis. Without a doubt there are cheap stocks in the current global equity market. Now, perhaps, we have the time to look for them instead of worrying so much about the Fed.