“Investors may be underestimating the degree of uncertainty about the future path of policy.”
– Jeremy Stein, outgoing member, Federal Reserve Board of Governors, May 16
“Monetary policy ought to be reacting to the data. We are on a path that says low for long and we have no plans to raise interest rates anytime soon, yet as the data keep telling us, we ought to be raising rates. . .We are closer than a lot of people might think.”
– Charles Plosser, President, Federal Reserve of Philadelphia, July 11
“The Fed is closer to its goals than many people appreciate . . .[we] are basically going to be near normal on both dimensions [unemployment and inflation] later this year. . . that’s shocking, and I don’t think markets, and I’m not sure policymakers, have really digested that that’s where we are.”
– James Bullard, President, Federal Reserve Bank of St. Louis, July 17
“I have grown increasingly concerned about the risks posed by current monetary policy. The time for an adjustment in monetary policy is fast approaching.”
– Richard Fisher, President, Federal Reserve Bank of Dallas, July 27
“If the labor market continues to improve more quickly than anticipated, then increases in the federal-funds rate target likely would occur sooner and be more rapid than currently envisioned.”
– Janet Yellen, Chairwoman, Federal Reserve Board of Governors, July 15
Federal Reserve officials have very nearly written our letter for us this quarter. Earlier this year we worried economic data were increasingly at odds with the Fed’s policy stance, a conflict that would eventually result in a sharp change in tone from the central bank. What has surprised us (and apparently the Fed as well) is the relatively sanguine response the market has had to this change. The market has an “I’ll believe it when I see it” attitude to the turn at the Fed; bond yields and equity volatility have actually fallen in the face of the Fed’s increasingly hawkish message. As we observed earlier this year, this is a market that is now hyper focused on incoming data, unable to see much beyond the next data point, and superbly confident in its own ability to get out of the way when the tipping point of data forces the Fed to act.
The reality, however, is that there is no tipping point or straw that breaks the camel’s back when it comes to timing the first rate hike in nearly eight years. Based on our own calculations and those of Fed economists, we’re a breath away from the policy goals the Fed set more than a year ago as the catalyst for rate hikes. However, given how long it takes to normalize rates, it is also important to evaluate the gap between the Fed’s policy stance and the distance from its stated goals to better understand just how reactive the Fed will be to incoming data. After all, monetary policy should largely track the Fed’s goals over longer periods of time. Today that gap is as large as it has been since 1975; in other words, policy is further from normal and the goals closer to being met than at any time in the past 40 years. As seen graphically (figure 1), this gap is the obvious catalyst for a more hawkish and urgent Fed (“sooner and sharper” may be the new “lower for longer”):
Figure 1: “Fed Goals and the Policy Stance,” Federal Reserve Bank of St. Louis
The single most important mitigating factor here is that the Fed has far more tools to deal with inflation than it does deflation. It may much rather err on the side of overshooting on its inflation target than stall a fragile recovery and have to deal with a deflationary morass like that which plagued Japan for two nearly decades. In other words, it may be willing to wait until it sees the whites of the eyes of inflation before acting.
On the other hand, it may not. Central bankers agonize over the right balance of employment and price stability, but historically have erred on the side of price stability (“only hawks go to central-banker heaven,” the saying goes). Famed former Fed Chairman Paul Volcker recently remarked, “All experience demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse.” Furthermore, should loose policy go as far as to create bubbles or other potential financial instability, the crude tools at the Fed’s disposal may not be enough to avert a different deflationary monster. That is the dilemma facing the Fed and which Chairwoman Yellen attempted to articulate in early July. Our educated guess is that the Fed would not have begun tapering nor be communicating a more hawkish stance were it not totally comfortable with its inflation and unemployment targets.
Interest rates may be the single most powerful force in capital markets. They are quite literally the cost of money and determine everything from the value of bonds to the price people are willing to pay for equities. We don’t think for a second that the process of rate normalization will be as uneventful as the market seems to be pricing in. No bell will ring or date certain set for unwinding what is now an extremely outdated policy stance. The idea that investors can simply get out of the way when the time comes is unlikely when considering how flatfooted they have been in the midst of interest rate volatility in 2013, rate hikes in 2004, 1994, and so on.
Investors aren’t getting paid much to take risk, so they’re taking more risk in an attempt to make up for it. We’d much rather use this opportunity as a pit stop; a time to fortify portfolios during which the cost of not being fully exposed is minimal but the cost of making a mistake could be large. Rain portfolios continue to be well hedged against equity market volatility while being tilted heavily away from interest rate risk. On a risk-adjusted basis, this positioning has been validated so far this year as most equity and bond markets have offered up mixed returns but continue to manifest strong sensitivity to interest rates. To paraphrase Warren Buffet, reducing risk may be uncomfortable, but not as uncomfortable as doing something stupid.