What The Fed's Present Position Means For Markets

“Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter, but if the economy surprises us, our judgments about appropriate monetary policy will change.”

– Janet Yellen, Federal Reserve Chair, in a speech Thursday, Sept. 25, in Amherst, Massachusetts.

The following was written prior to Yellen’s Amherst speech, but everything we have to say here is just as valid today as it was before she gave that speech.

We were fortunate to be in Indianapolis for a speaking engagement the day after the September 17th Federal Reserve (Fed) meeting. Our task was in response to a kind invitation from the CFA Indy and FPA of Greater Indiana Joint Forum. The group was an assemblage of fine folks in the financial services industry. They were lively and attentive. They asked important, precise, and targeted questions. My colleagues Bob Malvenda and Sharon Prizant were able to join me for this networking opportunity.

Let’s summarize and respond to some of the questions raised during the discussion.

Would a quarter-point rate hike be a big deal?

If $100 million in floating-rate debt is owed, the additional quarterly interest cost is slightly under $65,000. The flipside is when money is deposited into banks, money market funds, or other vehicles that hold deposits. They would have more earnings, equal to the additional interest. Thus, should the Fed raise interest rates away from zero, there would be a slight additional cost imposed on floating-rate borrowers and a slight additional amount of income paid to savers and lenders, who have experienced financial repression for the last seven years.

What would happen to fixed-rate borrowers if a quarter-point rate hike occurs?

The effect on fixed-rate borrowers depends on the adjustment amounts in the bond market. All things being equal, the short-term interest-rate rise may have the impact of raising some long-term interest rates. Some observers think that the sooner the Fed gets away from zero, the sooner long-term interest rates will stabilize or even fall. The Fed determines the level of short-term interest rates. It has the ultimate control and ability to set short-term rates wherever it chooses. Intermediate and longer-term rates are set by forces worldwide and reflect a number of elements in their pricing. Economic growth raises demand for longer-term funds. Inflation raises the need for inflation protection through a higher interest rate. Flight to quality by foreigners lowers intermediate and longer-term interest rates in US government securities. Requirements to invest against long-lived liabilities drive many institutions, such as insurance companies, into longer-term debt instruments, whether or not they want to own them. There are conflicting, diverse, meaningful forces that come together to set the intermediate and longer-term interest rates at any given instant. The Fed’s short-term interest-rate policy is only one of those forces.

Can the Fed also control the long-term interest rate?

Yes. The Fed can engage in unlimited transactions at any maturity level on the yield curve. A good example of this policy can be seen in the 1940s, during the four years that the US was engaged in world war. The Fed ignored inflation and other matters and maintained the long-term Treasury interest rate at about 2%. At the same time, the US government issued large amounts of debt to finance the war. The Fed bought what was necessary to keep the interest rate around 2%. The Fed kept the short-term interest rate very low during that entire period of time. The 90-day Treasury bill traded at a yield of 0.38 of 1%. Those bills never saw their interest rate change, regardless of the Fed’s unlimited activity. The Fed’s capacity to set a long-term interest rate and keep it there has been tested in history under the most adverse circumstances.

Why did the Fed leave interest rates unchanged at the September meeting?

The Fed cited a variety of reasons in their statement and subsequently in Chair Yellen’s press conference. The only reason that has been newly discussed in recent meetings is that non-domestic activity alters the decision process of monetary policy. That is a new approach for the Fed and opens a Pandora’s box of questions without answers. My colleague Bob Eisenbeis wrote about this in his Fed meeting analysis “The FOMC: Waiting for Godot.”

Think about how businesses, investors, and institutions in the US are supposed to understand Fed policy now that the Fed is looking at China or listening to the International Monetary Fund’s warnings. What happened to the issues concerning the domestic economy, such as recovery in the labor force, the unemployment rate, and the inflation outlook, or all the other things that Fed speakers have been talking about incessantly for months? Has the growth rate in China suddenly become more important than the inflation outlook of the United States? Is a warning from the International Monetary Fund suddenly of greater importance than the recovery, or lack thereof, in the US labor force? The Fed has now sent a mixed message to markets, market agents, and businesses.

What happens to the dollar?

The dollar should strengthen as the Fed starts to normalize policy. A different issue now is at hand: is the Fed worried about the dollar being too strong? The Fed has not said so directly; however, they have implied that a strong dollar weakens US exporters. In our view, this is a dangerous area for the central bank. It is dangerous especially when other central banks (e.g., the Bank of Japan and the European Central Bank) are engaged in activities – more likely by design than by accident – that seek to weaken the yen and the euro. In a world of competing central banks and currencies, all currencies cannot be weakened at the same time. There is no way that the planet Earth can devalue all of its currencies against the currency of Mars. It just does not work that way.

What will happen in the future?

The debate is ongoing about when the Fed will make its first move. There is some discussion that an initial rate hike could occur at the October 2015 meeting. Many think that is not likely because there will be no press conference following that meeting, although Chair Yellen could call for one if she wanted to. Therefore, the December 2015 meeting could be the next target for liftoff. Others think we will not see the first Fed hike until 2016 or maybe even 2017. One of the peculiarities of the September 17th Fed meeting was the revelation that a member of the Federal Open Market Committee (FOMC) forecast a negative US interest rate. Bob Eisenbeis has dissected the inconsistencies that led to that forecast. The fact is, however, that the forecast was there and was dismissed by Chair Yellen. In doing so, she acknowledged that one of the FOMC members had in fact raised it for discussion.

What are the implications of the September Fed “dots” and forecasts?

Some things are clear. There was a shift to a slightly more dovish stance by the committee as a whole. One committee member forecast a negative interest rate, and others moved out on the curve as they made their future quarterly estimates.

It is important to understand how these estimates work. Each member of the FOMC makes his or her own forecast. The forecasts are then grouped and made public in a presentation, as Bob has explained. The key is that the name of each forecaster is anonymous and is not associated with a specific forecast. Thus, the Fed purposefully practices opacity instead of transparency. Some FOMC members are transparent, such as Jeff Lacker, president and CEO of the Federal Reserve Bank of Richmond, who dissented on the vote and publicly explained his decision. Others who offered forecasts, including Jim Bullard, president and CEO of the Federal Reserve Bank of St. Louis, and John Williams, president and CEO of the Federal Reserve Bank of San Francisco, described their positions and what they saw coming. But others remained silent.

Would anything improve if every FOMC member attributed their name to their forecast?

Transparency enables market agents to evaluate and draw informed conclusions about the future. Opacity or anonymity adds an uncertainty premium. Market agents could put together scenarios for their own decision-making process if they knew who said what. Instead, they have to guess.

Which dot represents Chair Yellen or Vice-Chair Stanley Fischer? Which one represents William Dudley? These questions only add to an uncertainty premium in the markets and confusion on the part of US central bank observers.

Does the Fed have tools other than the short-term interest rate?

Yes. They have already demonstrated their ability to expand and contract the size of the Fed’s balance sheet. We have seen three rounds of quantitative easing (QE). The Fed’s balance sheet is now five times the size it was prior to the financial crisis. QE is an additional tool, although there is speculation that it has lost its efficacy.

Another tool is the Fed’s changing its asset holdings mix. Before the financial crisis, the Fed held Treasury bills and notes that roughly constituted the asset side of its balance sheet. Reserves deposited at the Fed, along with currency that circulated worldwide, made up the liability side of the balance sheet. That is what the Fed balance sheet looked like for years. When QE was launched and then expanded, the excess reserves in the banking system became an additional, large Fed liability. The excess reserves became huge. At the same time, the additional assets purchased enhanced that side of the Fed’s balance sheet. The balance sheet expanded five-fold on both the asset and liability sides.

The Fed also engaged in a composition shift of those assets. At one point, the Fed reduced its holdings of Treasury bills to next to nothing. It launched into the acquisition of federally backed mortgage securities and intermediate- and longer-term Treasury securities. During that time, the Fed lengthened the duration of its balance sheet from approximately two to approximately six. Thus, the combined five-fold increase in the balance sheet’s size was coupled with a tripling of the Fed’s asset duration. Note that the liability side (excess reserves and currency in circulation) remained short-term.

Now the Fed can undertake the alteration of the balanced sheet’s size by either selling assets or allowing them to mature. It can also intervene by altering asset duration on the balance sheet. When the Fed increases asset duration on its balance sheet, it extracts that duration from the market. It therefore causes interest rates on intermediate- and longer-term bonds to fall.

When the Fed decreases its asset duration, the reverse is true. The Fed has three tools now in play: (1) setting the short-term interest rate (the traditional mechanism), 2) expanding or contracting the size of its balance sheet (the result of successive QE rounds), and (3) altering the duration of its assets (it has been doing this for the last six years). There are a lot of moving parts worldwide that impact the use of each of these tools. It is not clear from the evidence we see that the Fed has resolved how to incorporate these moving parts in a policymaking system. What we have is now a very complicated structure for monetary policymaking. Therefore the Fed introduces confusion rather than offering clarity.

What does the Fed’s present posture mean for bond investors?

The first indication is that short-term interest rates are going to remain lower for a longer period of time. We eventually will get a liftoff, followed by a gradual path of increases. The Fed is more heavily influenced by events abroad than we originally thought. We see short-term interest rates worldwide close to zero, or negative, and falling. The downward pressure on short-term rates everywhere seems to be consistent with the Fed’s taking a globally influenced position of remaining near zero. For longer-term instruments, the Fed is indicating that they will remain at lower rate levels longer than we originally expected. Bond investors who have feared rising interest rates, kept duration short, and paid a price for doing so are likely to confront a continuation of this dilemma.

At Cumberland Advisors, we have not been absorbed by fear of rising interest rates. We continue to take advantage of intermediate- and longer-duration bonds and barbell structures. By doing so we have generated additional yields and returns for our clients. Many investors in the bond world have continuously favored shorter-term maturities for fear of rising interest rates. That has hurt their portfolios and denied income to the portfolio beneficiaries. It is likely that this state of affairs for bond investors will continue.

We favor spread product in the bond market over government securities and intend to stay with our barbell strategy and hedging devices.

What about the stock market, real estate, and other asset classes besides bonds?

When the interest rate is zero, the theoretical asset price, discounted at a rate of zero, is infinity. The math is straightforward. When the assumed interest rate is lower, the asset price is higher.

For the last six years, Cumberland Advisors has had a bullish position on asset prices. We were motivated by the fact that the global interest rate was trending toward zero, or at zero. Recently we have had the added phenomenon of negative interest rates throughout Europe.

We think lower interest rates will persist. That means asset prices will rise. Stocks, collectibles, real estate, futures of all types, and various types of nuanced specifics such as Bordeaux contracts, all have an upward pricing bias when the interest rate seems to be set perpetually at zero.

Will we eventually get some inflation? Will that inflation cause the interest rate outlook to change?

“Eventually” can be a very long time. Twenty years of zero interest rates in Japan have not brought about inflation there. In the US, the central bank admittedly has difficulty achieving its basic inflation target of 2%. In Europe we see the same phenomenon. In other places, price levels are downward. Commodity and oil prices also support this lower-inflation for-longer outlook.

The long-term answer is that if we wait long enough we will get some inflation and eventually we’ll see higher interest rates. However, that might be years or decades from now. There is no way to know.

What should be done in the US stock markets and elsewhere?

We like stock markets where we can diversify an investment mix. That is why we use exchange-traded funds (ETFs). The US stock market has an upward bias in price as long as US interest rates stay very low. The same is true of stock markets in other places, such as Japan and Europe. We expect those stock markets to work their way to higher prices.

Which US stock market sector should be avoided?

We continue to be at maximum underweight the energy sector. We have done this since the oil price was above $100 a barrel. Although gradual forces are at work to bring about some stabilization, we think it is too soon to enter the energy sector. Six months or a year from now, the US should begin to see new levels of output in oil and natural gas. Liquefied natural gas exports are evolving, and the energy patch (i.e. banking facilities, organizations, and companies) must face the credit dilemma that its lenders imposed on it after the oil price was reduced by half.

Does any sector stand above the others?

Utilities. We like the utilities sector for several strategic reasons. First, think of the Utility ETF as owning a basket of all the utilities in the United States – not a single stock selection but all of them. Second, we are able to forecast that US electricity consumption is likely to grow linearly at a single-digit rate for a very long time. Lastly, this is an industry that does business in US dollars. It is mostly domestic and not subjected to the fluctuations of the foreign currency markets.

We value the utility sector using an ETF to position ourselves. The current yield is about 3¾%, or nearly 150 basis points higher than a 10-year riskless Treasury obligation. The outlook for growth in earnings, which will be used in part to support rising dividends, is for a single-digit compounding growth rate for a very long time. We see nothing on the horizon that alters the favorable outlook for utilities. We also see a large possibility for market pricing enhancement, given the stable industry characteristics and the ability to forecast its earnings, dividends, and growth rates with some level of confidence. The utilities sector it is our most overweight position.

We thank the CFA Society of Indianapolis for the invitation to speak at their event. The hospitality in Indianapolis was gracious and welcoming. The energy level in the room was superb. The city is inviting with its monuments, museums, and revitalized downtown. Even the weather cooperated.

Lastly, the Fed’s meeting the day before our remarks gave us something more to talk about. I guess that we should thank the Federal Reserve as well.