Facts about the Fed: An Inside Look

There is an excellent way to cut through the misleading commentary about the Fed.  You will learn a number of useful facts, and feel less nervous about what Fed Governors say.  Not only that, it is an enjoyable way to spend a couple of hours.

Read Laurence Meyers book, A Term at the Fed.  You can take it to the beach or read it on the plane.  As I was reading it, my wife kept asking me what was so funny, so I guess it also has some humor.  At least some of the prof-style laughs….

Here are a few of the things you will learn:

  • The importance of staff.  These are not a bunch of research assistants.  They are talented and able economists who have a significant impact on thinking and policy of the governors.
  • How consensus is achieved.  It does not all happen at the meetings.
  • The Fed has twin goals.  It is not just about price stability.  The economy matters.
  • Inflation targeting has opposition, including Donald Kohn, who had several important staff roles before his appointment as a Governor.

There is also a lot of color about speeches by Governors – -what they say and the possible limits on them.  This is good to know.  There is independence of thought and action, but also a sense of responsibility.

This is a good read. It is a book that will make you a better investor in the current trading environment of "All Fed, All the Time."

Foolish Fed “Facts”

As I write this, Erin Burnett is leading a CNBC discussion about the possible strength of tomorrow’s employment report, especially given the strong forecast released yesterday by ADP.  If it is a strong report, everyone will speculate about the likely implications for the next Fed meeting.  We’ll probably see something like the following discussion of whether 25 basis points is enough of an increase:

"Why does this matter? Why do we focus on this? Because, once again, about 50% of the stocks in the S&P 500
will do worse with a rapid hike in the federal funds rate. Another 50%
— meaning all stocks — will be affected if the Fed panics and says
that we have an inflation problem. And if the Fed takes rates up huge,
you can have all of that Dow Chemical
dividend you want, I will take cash.  In
other words, it matters tremendously. And that’s why, if we get a 50
beep increase off this number, then you can say that the earnings
estimates — the lifeblood of the market — are too high for 50% of the
market. Twenty-five?   And we can make it up with good
business. I find myself constantly trying to explain why we talk about
these numbers so much. But the simple answer is that equities trade off
of rates and growth of earnings. When rates go too high, we don’t care
about the darned growth of earnings."

This comment represents how many people are thinking as the Fed ponders whether to take rates higher, and by how much.  There is just one problem.

It was written two years ago.

That was before the current tightening cycle even started.  When I first saw this, in June of 2004) written by one of the most visible and influential commentators, I could hardly believe my eyes.  The Fed funds rate was at one percent.  The Fed was about to embark on a long series of gradual increases until they reached "neutral" as they defined it.  The effects of monetary policy changes lag by six to nine months.  How could it possibly matter whether the first hike was 25 or 50 bps?

At about the same time CNBC interviewed a big fund manager (nearly $1 billion AUM) who was also asked about the size of the Fed move.  He answered that they should try 50 bp because "they could take a look for a few weeks and cut it back if necessary."  Once again I wondered, "What planet is he on?"

If these were isolated examples from random blogsters or something, it would not matter.  The quoted authorities are both big-time, Harvard-educated, experienced fund managers, who get heavy TV exposure and speak with real authority.  The average person takes it at face value.

And it is typical of much of the "research" during this time.  I have correspondence from the research head of a financial service saying that there is a "nearly perfect correlation" between stock market returns and the direction of interest rates.  I’d like to see that study.

There is a way to get good information about the Fed.  I’ll explain in Part II of this Fed Series.

An Interesting Week

Most of the writing I do is on sites exclusively for clients.  This is especially true for the analysis of specific stocks.  Sometimes a theme is also suitable for "A Dash," and tonight is such an occasion.  So here is part of my nightly investor commentary, omitting our daily result and position discussion.

CNBC just reported that the market was up strongly today because of strong corporate earnings. Briefing.com suggests that sense there was no Fed news nor economic news of significance the market could pay more attention to earnings.

Today and yesterday show how little sense there is in most attempts at “explaining” specific trading day results, even moves of 1% or so. Journalists are required to write something, but we do not have to believe it!

There was good earnings news from Morgan Stanley and from FedEx. True enough, but no different from the reports of Merrill, Goldman Sachs, and others in the investment banking space, nor Caterpillar and other cyclical companies.

On May 10th the market focus changed to all Fed, all the time. We got a parade of Fed governors making speeches about their inflation vigilance, plenty of market punditry suggesting that the Fed could not stop inflation nor save the economy. Sector PE multiples were crushed (even further by our lights) for anything related to economic strength — energy, construction, steel, machinery. Many of these stocks declined by 20% or more in about a month. If the economy was to be weak, then technology must also be bad. Since trading and investment banking would be bad, those stocks should also be sold. And what about the yield curve? The fact that it did not matter a few months ago did not deter the same folks from trotting out the same arguments about the economy.

There can be a self-fulfilling prophecy about such stock declines. Analysts started to report that the market was “telling us something” about the economy, and that the Fed should listen. In other words, the market moved lower because of a concern about what might happen. Then some interpreted it as evidence that something would happen.

Over the last few days the sentiment on the economy has changed a bit. Not only are corporations reporting great quarters, but the CEO’s are making more confident statements about global economic strength.

We expect a significant shift in attitudes about the economy, corporate profits, and the relative value of stocks. Market moves like we have seen in the last week illustrate how this might happen.

After the Fed

What will happen when the Fed is finished with the tightening cycle?  To get a dash of insight, take a look at the Fed Funds rate over time.

Fed_funds

When trying to predict something, you want to look at similar instances in the past.  There is a piece of research from a big-time firm that is making the rounds.  The statement is that the market will decline in the period six months and one year after the Fed is finished with the cycle.  The research looks at ALL past tightening cycles.

Is this correct?  Take a look at the chart and see what you think.

Hussman: Fed Action Won’t Boost Stocks

The problem with the comparisons John makes is that all of his "price/peak earnings" periods are not equal.  A valuation approach that completely omits interest rates leaves out the biggest asset allocation comparison faced by both managers and individuals.  Here’s the story, then I’ll elaborate.

Link: Hussman: Fed Action Won’t Boost Stocks.

Excerpt from John Hussman’s latest weekly essay: …attention has turned to the prospect that the Fed has finished, or is just about to finish, its tightening cycle. Isn’t that alone a great reason for bullishness here? …If you …

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Yield Curve — an Indicator, not a Cause

Understanding the causal relationship is crucial in using any indicator.  Lacy Hunt says that reducing M2 growth will slow the economy, but what does this have to do with the slope of the curve?  Meanwhile, there was a lot of economic and media commentary today citing the same arguments I made yesterday.  I’ll summarize below, but first review the Hunt argument:
Link: Explaining Yield Curve Inversions.

The Yield Curve briefly inverted — twice — Monday. As we noted yesterday, the deeper and longer a curve remains inverted, the more potentially significant it is. That factoid has been overlooked by many commentators. Following yesterday’s post about …

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