Why The Fed Did Not Go 'Risk On' And What To Do Now

by: DoctoRx

 
Summary
 
- The stock market has taken the Fed's statements and Chair Powell's Q&A bullishly.

- I rarely object to a bull move in stocks, but I'm back to seeing matters as justifying a risk-off posture to the markets.

- A rationale for interpreting the Fed's positioning more negatively is presented.

- Treasuries may again be positioned to outperform equities, as they have done since I proposed that outcome in October.


What the Fed did and said Wednesday
 
Facts first, interpretation second, trading and investing thoughts last.
 
Here is the key part of what the Federal Open Market Committee's statement said Wednesday:
...the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee's symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.
Commentators noted that "patient" is a new word, and Fed-watchers watch for any word change such as this to divine changes in the FOMC's point of view of the economy.
 
What was less discussed and therefore may be more important to traders was this phrase:
... global economic and financial developments.
Putting in the term 'global' is very good news for US-based investors in my view, as I'll get to later.
 
But the above is not a 'risk on' move by the Fed.
 
There were two other key related statements put out by the committee. One was regarding the ongoing shrinking of the balance sheet:
Decisions Regarding Monetary Policy Implementation 
...The Committee directs the Desk to continue rolling over at auction the amount of principal payments from the Federal Reserve's holdings of Treasury securities maturing during each calendar month that exceeds $30 billion, and to continue reinvesting in agency mortgage-backed securities the amount of principal payments from the Federal Reserve's holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $20 billion. Small deviations from these amounts for operational reasons are acceptable.
So they are continuing to shrink the money supply by the same $50B per month. This is an ongoing 'risk off' story. Here is the second related statement, a rare if not unprecedented ancillary commentary by the Fed. This is of great importance, so I reproduce all the important text in its entirety (emphasis added by me):
Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization 
After extensive deliberations and thorough review of experience to date, the Committee judges that it is appropriate at this time to provide additional information regarding its plans to implement monetary policy over the longer run. 
Additionally, the Committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalization program.  
Accordingly, all participants agreed to the following:
  • The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve's administered rates, and in which active management of the supply of reserves is not required. 
  • The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.
Since everyone knew the Fed was on hold for some time regarding the Fed funds rate, this is what really got stock traders excited. I will discuss the above statement in the next section.
 
Why the balance sheet statement is important
 
The Fed is agreeing with its critics that its now-abandoned goal of normalizing monetary policy represented medicine that was harming the patient. To wit:
 
In the good old days, meaning from the Truman administration on to the Great Recession, the Fed handled its role in the economy by adjusting monetary reserves in the banking system.
 
There were normally no (or almost no) excess reserves; the banks preferred to lend them out or else invest them in higher-yielding opportunities. So, the Fed did not have to "print" or remove much money quantitatively to affect interest rates; the system was finely tuned. Quantitative easing, the famous (or infamous, if you prefer) policy that the Fed copied from Japan during and after the Great Recession, changed that, forcing the Fed to directly control interest rates as it has been doing rather than work indirectly on a system with minimal to no excess reserves by simply buying or selling relatively small amounts of Treasury bills. So it's going to stay with the current system that appeared to be working well.
 
That is not 'risk on' either.
 
The longer bolded section in the second bullet point basically implies that the Fed is open to ceasing its balance sheet normalization much sooner than it had previously indicated. That's more of a risk-on story. What's being interpreted as risk-on is the further clear implication that the Fed is willing to do QE again, i.e. "use its full range of tools" if lower rates did not revive the US (and global?) economy.
 
Is that really risk-on? I do not see it that way.
 
Didn't the Fed continue tightening, and isn't the market celebrating the wrong thing?
 
My answers to my questions: yes; yes.
 
Monetary policy works with a long lag; Chair Powell explicitly acknowledged that several weeks ago. The lag is more than a year. So the last 4 or 5 interest rate increases are still slowing the US and therefore the global economy and will tend to do so for approximately 12 more months. The US is not an isolated island, and these are some headlines from Thursday:
German retail sales slump at fastest rate in 11 years; Italy in recession amid sluggish eurozone and China says its manufacturing activity contracted for the second-straight month in January.
All this is consistent with an OECD-defined global recession that may be underway right now. Also consistent with a recession is the plunge to now-ridiculous interest rates on high-quality 10-year government bonds across the globe. These include, as of Thursday night:
  • Canada = 1.88%
  • UK = 1.21%
  • Australia = 2.23%
  • New Zealand = 2.19%
  • Germany = 0.15%
  • France = 0.55%
  • Portugal = 1.61%
  • Switzerland = -0.31%
  • Japan = -0.02%.
 
At 2.64%, the US is a star, reflecting a good economy. Importantly, none of the above countries have active QE (bond-buying by the central bank) except Japan (to my knowledge). In fact, the European Central Bank spent last year tapering its version of QE and ended QE at the end of the year. Instead of rates increasing with the lack of the ECB as buyer, they have plunged.
 
When this is happening, the European economy is signaling some distress in my view. And when Canada, Australia and New Zealand, none of which ever did QE, are seeing such low and declining rates, I assume they are participants in a troubled global economy.
 
This is not a risk-on situation; neither is it an inflationary one. It bespeaks weakness, with risk aversion by banks that know much more than I and perhaps you do.
 
Even if the US economy is slowing, that is also not a risk-on status. What is risk-on is the opposite: the economy has slowed and troughed. and the Fed is stimulating it to do what it is ready to do without the stimulus, which is to expand again. This is different. The global economy may be in recession (which is not defined as absolute contraction on a global scale, just severe slowing in growth) and the Fed has neither lowered rates nor stopped (or even slowed) its pace of liquidity withdrawal.
 
So, what should investors do? Part 1, what I have done and why
 
Of course, I can't give investment advice, but as commentary, here's what I saw and laid out vociferously in October for anyone interested in my thoughts. I both criticized the Fed and switched my personal investment focus from both stocks and bonds to a heavy bond exposure.
 
For documentation and potential review by you, here are two of my Fed articles from October which criticized the rate hikes in conjunction with the reverse QE policy (which continues):
Yep, The Fed's Going Too Far, And Trump Has A Point: Analysis and Reign Of Error: What May Be Next Until, And When, The Fed Relents.
I continue to believe that the Fed erred in raising rates in December, that it erred in continuing to reverse QE, that it is erring in not lowering rates now, and that it is erring by not ending the reverse QE policy immediately.
 
As far what to do, I acted on this article from Oct. 12, where these were the key summary bullet points:
Why Lower Rates On Treasury Bonds Won't Be Good For Stocks
  • As shown, the reversal of QE now underway is taking hot money from the markets. 
  • While some think that lower rates on bonds are good for stocks, I believe that going forward, a bull market in one asset class means a bear move in the other. 
  • Thus as in 1999, I expect a stock bull market to coincide with rising rates (bear move in bond prices), and vice versa.

Since then, an ETF for the S&P 500 (SPY) has dropped from $277 to $270, a total return of about -2%. In contrast, a T-bond fund (TLT) with a long duration has risen from $114 to $122, a total return close to 8%. The delta in these 3 1/2 months has been 10 percentage points in favor of the long bond over the seemingly invincible SPY. And it required the help of the Plunge Protection Team beginning work over the Christmas holiday to get stocks back up this high. Absent the PPT, I think the outperformance of Treasuries would have been much higher.
 
If people ask me how I spent the second week of October, I would answer, selling stocks and buying long term bonds.
 
That was then.
 
What to do? Part 2, not going risk-on yet
 
What has fundamentally changed in the past several months?
 
It's the point the Fed made in its main statement, namely that the global economy has weakened and may be in recession. In that setting, the Fed has to either be on hold with rates or else cut them. If it does not cut short term rates, then the usual pattern would be for long term rates to decline. In one case or the other, high quality/safe haven US bonds tend to do well with price appreciation (lower yields) and the coupon. Accentuating that tendency is the ongoing fact that the Fed continues to force bank deposits and money market funds (which ultimately tie back to bank deposits) to buy $50 B per month of Treasuries and GSE debt that the Fed is unburdening itself of.
Here's an analogy for investors who think the Fed has gone risk-on, rather than just cooperating with the Plunge Protection Team. Let's look back at 2014, when the Fed was tapering QE 3. Everyone knew the stimulus was going to end, but the stock market still surged throughout the Taper, then stagnated as it ended.A 5-year chart of the SPY shows this:
Chart Data by YCharts

The SPY went nowhere from late 2014 to Q2 2016, with a downside bias. That's what happened when QE 3 ended.
 
Now think of today's reversal of QE 3 at full blast, a pace that only began in October last year, which not coincidentally in my humble opinion marked the top of the market. The very best I can say about the Fed's plans to retain a larger balance sheet than it had planned is that it might be analogous not to full-blown QE 3 (a 2013 event that sent the SPY straight up) but perhaps to the 2014 Taper.
 
Given this analogy along with the global economic situation, all the known worry points such as Brexit, US-China trade relations and the ongoing investigations of President Trump, I think the stock market has had a knee-jerk reaction and is vulnerable.
 
What to do? Part 3, bonds may still have more fun
 
Here's the dynamic I was pointing to in the Oct. 12 article about having finally flipped to favor bonds over equities:
 
When the Fed reverses QE, it shrinks the basic money supply of the US. Initially, this puts pressure on all financial asset prices, as there is less "hot money" around than there was due to full-blown QE. So it's anyone's guess as to what asset class would be in favor, but one thing I was pointing out almost all of last year was that cash was no longer trash. Cash was hated but it was getting scarcer and therefore more valuable. Thus I was not surprised that cash outperformed almost every other major asset class last year.
It could happen again for cash, but Treasury bonds are "cash-like." That is to say that they are guaranteed to turn into cash via revenues from taxation or from the magical electronic printing press of the Federal Reserve. They will turn into cash and they will pay interest as promised.
 
You can take that to the bank. But cash has limits as an investment. And by cash, I mean high-yield insured bank deposits, typically Internet-accessed, or money market funds. The general principle is that any investment that is virtually interchangeable with dollar bills that just sit in your wallet earning no interest is not really a good investment; it's just a placeholder. Interest rates might drop, and you have nothing. So, a Treasury bond becomes - in my thinking - the next asset to come into favor if cash strikes investors as played out, i.e. short term rates may stabilize and may drop.
 
What about the SPY? I think it's a tougher call with it back near $270. That puts it at 18X GAAP projected P/E based on consensus around $150/share for S&P 500 earnings this year. This is high given that after-tax margins in 2018 were the highest for any year since at least 2006, and by a good deal. If one adjusts for more normal after-tax margins, I get a P/E well above 20X. Given a global economy that may already be in recession, I find that unattractive.
 
But, on a trading basis, anything can occur, as we all know.
 
Summary
 
I disagree with the market's reaction that the Fed has caved to the stock market and has gone risk-on. Rather, I give a golf clap to Chair Powell and the FOMC for being alert enough to see that the global economy has weakened, and therefore the Fed needed to take a softer tone. It's only a golf clap, though, because I believe the Fed is already too tight, that it should not have raised rates in December and should never have engaged in reverse QE to anywhere near the $50 B/month level. Thus I'm keeping to a generally risk-off investment strategy until I have a clearer picture of the numerous moving parts to the current economic and financial scene.

As always, I am sharing my own thoughts and plans, expressing opinions and projections that may not work out well. Nothing herein represents investment advice of any sort; different points of view make for good two-way markets.

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