Up and Down Wall Street
Fed Stuck in a Time Warp
As was the case a decade ago, the Federal Reserve is preparing for rate hikes. And as was the case then, the yield curve is sending a warning.
By Randall W. Forsyth
Isn’t this where we came in?
The weekday version of Up and Down Wall Street started on Barrons.com 10 years ago this week, and the remarkable thing is what hasn’t changed in the past tumultuous decade.
As in 2006, the Federal Reserve is in the early stages of raising its policy interest rates—after a period of unprecedentedly low short-term rates, which were put in place to counter the impact of a plunge in asset prices. The subsequent rate hikes were supposed to mark a return of normality and allow an elongation of the recoveries in the economy and the stock market.
As things turned out, instead of a soft landing there was a crash. And although the current expansion is about to enter its eighth year, the economy continues to feel the effects of The Great Recession.
In addition to the calendar, these recollections were brought to mind by central bank officials’ strong suggestions that second interest-rate hike of the current cycle will be on the table at the June 14-15 meeting of the Federal Open Market Committee. Minutes of the April 26-27 confab, released Wednesday, underlined that message offered by a number of Fed district bank presidents.
Those signals will be amplified Thursday by two of the most influential members of the FOMC, Fed Vice Chair Stanley Fischer and New York Fed President William Dudley. And on May 27, the one voice that counts the most, that of Fed Chair Janet Yellen, will be heard at a speech at Harvard University.
Ahead of the pronouncements of other Fed presidents, and after the release of the April FOMC minutes, the probability of a 25-basis point (one-quarter percentage point) increase in the federal funds rate target range at next month’s meeting, to 0.5%-0.75%, increased to 30%, from 16% shortly before, according to Bloomberg’s analysis of the fed-funds futures market. Just last Friday, the probability of such a move was put at just 4%.
What’s changed? Apparently, mainly the markets. Even though the FOMC minutes noted that indicators of domestic demand had been “disappointing,” the panel explained the shortfalls as reflecting “possible measurement problems and other transitory factors.”
But financial conditions improved, with higher equity prices, tighter credit spreads and a weaker dollar. So, with continued improvement in labor markets, the dollar no longer rising and oil prices no longer falling, inflation was on track to move back to the FOMC’s 2% target.
If—and this is a big if, as Peter Boockvar, chief market analyst at Lindsey Group, emphasizes—economic data line up as the Fed expects, that would leave open the possibility of a hike at next month’s FOMC meeting, according to the April meeting minutes.
In that case, the May employment data, due to be reported June 3, will figure greatly in setting the odds of a move at the coming Fed policy-setting meeting, writes Joshua Shapiro, chief U.S. economist at MFR Inc.
That said, the improved odds of a June hike largely reflect the rebound in risk markets—higher equity prices, higher oil and other commodity prices, lower bond yields and, especially, a less-strong dollar. But those improvements are the result of the a shift in Fed rhetoric, says Steve Blitz, chief economist of ITG Investment Research.
The FOMC, ironically, didn’t acknowledge that the improvement of market conditions was the result of Fed officials’ own pronouncements, Blitz adds. The officials also ignore the impact of their previous statements talking up rate hikes in 2014-15, which Blitz says contributed to slower growth subsequently.
For the proverbial person from Mars, who is blissfully ignorant of the economic theories and models of the Fed’s reaction function, there seems a simpler explanation.
The Fed would like to move the fed funds rate target away from zero—but only when the asset markets allow. Last December, when initial liftoff took place, the Standard & Poor’s 500 hovered around its historic peak near 2100. At that point, expectations of four rate hikes in 2016 were “in the ballpark,” in the words of Fed Vice Chair Fischer last January.
The stock market then swooned into correction territory, with the S&P 500 falling close to 1800 in early February. Circumstantial evidence points to some accommodation, with the Fed backing off from the full slate of expected rate hikes. More important, the dollar’s rise was arrested, which in turn boosted commodities and especially oil. For the capital markets, high-yield bonds rebounded, a welcome improvement in this highly energy-dependent market.
What’s striking is the Fed officials’ current underestimation of the impact of their words and actions, as happened a decade ago. The clearest signal then was the flattening of the slope of the yield curve—the graph of bond yields of increasing maturity. As pointed out on numerous occasions in this space back then, the failure of long-term interest rates to follow short-term rates higher implied that investors anticipated weaker economic conditions ahead. That is the classic portent of a flatter yield curve.
The current curve, as defined by the spread between the yields on two- and 10-year Treasuries, is the flattest since November, 2007, according to the St. Louis Federal Reserve. The S&P 500 peaked in the preceding month, and the simmering credit crisis exploded in 2008.
Former Fed Chairman Alan Greenspan called the situation a “conundrum.” His successor, Ben Bernanke, pointed to a global saving glut, which depressed long-term bond yields. Neither recognized the more mundane but more dire implications from yield-curve flattening, however.
While most economists now assert that the economy will motor through a Fed rate hike or two, MFR’s Shapiro thinks a June increase could be the last, not just the second, in a long series. “A weakening labor market and an overall market fraying around the edges will keep the Fed on hold for the balance of the year before further weakness leads to easing moves in 2017,” he writes.
Let’s simplify the FOMC’s reaction function further. If the S&P 500 is around 2100 when the FOMC meets in June, the panel will hike rates. The likely subsequent negative stock market reaction (plus renewed dollar strength) would likely put further Fed rate increases on hold.
So, a decade on, the markets remain dependent on the Fed. What’s changed is how dependent Fed policy is on the markets’ actions.