Tags: markets | Fed | Congress | investing

Let Markets Self-Correct With Sidelined Fed, Congress

By    |   Monday, 05 October 2015 11:24 AM

An interesting side benefit of the Fed having pegged interest rates effectively to zero and having accomplished so little with QE, is that we get to see markets’ self-correcting tendency.

Consider what has happened over the last year or so since the Fed made it clear their goal was to start normalizing policy, that is, raise interest rates. As I’ve pointed out several times, the effect was as if the Fed had actually already hiked rates.

Short-term interest rates rose, long-term rates rose but less, the dollar strengthened and inflation expectations fell. Now, over the last few weeks, as it has become more obvious that a hike is not in the immediate future, the markets have responded as if the Fed actually cut rates. Short and long term rates have fallen and the dollar has pulled back. All this movement and the Fed has done nothing but talk — incessantly.

The one variable I didn’t mention — inflation expectations — hasn't reacted to the market’s virtual rate cut. Indeed, inflation expectations have continued to fall, even as the bond market cuts rates, an indication to me that the rate cut so far hasn’t been sufficient to stem the economic slowdown.

It may be that, with a debt load that has continued to grow since the 2008 crisis, rate cuts just won’t be sufficient to revive growth. I’d say that is exactly what 5-year, 5-year forward inflation expectations – one of the Fed’s preferred inflation gauges – are telling us now, plunging to levels only previously seen in the depths of the crisis. Would it really matter if the Fed cut rates or announced another round of QE? Is it really the case that the difference between growth and contraction is less than 100 basis points?

What would happen if the economy continued to deteriorate and the Fed did nothing?

Let’s approach that from a different angle. What would the Fed want the market to do if the economy continues to deteriorate?

Well, presumably, based on what they’ve said in the past, they would want lower long term interest rates and a weaker dollar.

The interesting thing is that is exactly what the market would deliver if the Fed did nothing.

We’ve just seen it happen even as Janet Yellen was choking on her own explanation/justification for a rate hike. Just as Indiana Jones is irrelevant to the outcome of the Raiders of the Lost Ark movie – the Nazis would have opened the Ark and died regardless of whether Indiana was there or not – the Fed is irrelevant to the economy and the market – except possibly when it acts as a lender of last resort.

Weak Economy

Which brings us to the stock market reaction to what was one of the worst weeks for economic data I’ve ever seen outside a recession.

The reports last week were almost uniformly negative and less than expected, particularly on the manufacturing side of the economy.

If it weren’t for the automobile industry financing anyone with a pulse (for terms out to seven years), manufacturing would probably be in a depression right now. It is not, in my opinion, out of line to say that the manufacturing economy is in recession right now. The employment report might be taken as evidence that the rest of the economy is starting to succumb to the pull of the manufacturing side and the malaise of the rest of the global economy where it isn’t just manufacturing that is in trouble.

Nevertheless, stocks took the weak data as evidence that rate hikes were off the table, that a new round of easing might well be in the cards and rallied smartly off the lows Friday.

I suspect anyone buying with that expectation will be mightily disappointed with the result. I can see the logic though. If the rising dollar was the cause of all this turmoil and now it is dropping along with U.S. growth and rate expectations, won’t that reverse the negative trend?

Well, maybe but it isn’t quite that simple.

The rising dollar may have put fear into the hearts of dollar debtors everywhere but reversing the trend will probably not be sufficient to grant them courage. They aren’t going back to the mindset that prevailed before the dollar rise.

That includes anyone whose business model was predicated on a cheap dollar and high commodity prices. The fracking industry that is at the heart of the U.S. slowdown won’t be the same even if the dollar falls and oil prices rise.

Their lenders have learned a lesson about risk they won’t forget in a few weeks or months. Merely reversing the rise of the dollar, the effects of the Fed’s virtual rate hike, will not put our Humpty Dumpty economy back together again.

Of course, just because the market would self-correct over time doesn’t mean the Fed will just do nothing. It does seem though that the Fed’s dependence on language as a policy tool means monetary policy will not be as timely as it was in the past.

The Fed has spent over a year preparing the market for a rate hike and if they hold true to their “don’t surprise the market” policy, it will take time to execute a rhetorical U-turn.

I suppose they could just abruptly change direction but one wonders what the market reaction would be if they announced a new round of QE or cut interest on reserves to zero. That might induce panic – what does the Fed know that I don’t? – that creates the very recession they are trying to prevent.

There is a belief that the Fed is at the center of the economy and that their moves and pronouncements are all important. I have always thought of the Fed the way I think of most government agencies.

They have great potential to make things worse but only limited ability to make things better. The market is the 400 pound gorilla, not the Fed. The market self corrects no matter what the Fed wants. If recession is in the cards, there is little they can do about it.

And I would just stress that I don’t know whether a recession is near. But if it is, the downside for stock prices is considerable; the last two recessions saw stocks fall 50 percent.

Manufacturing Recession?

For now, what we know is that the economic data continues to deteriorate. Manufacturing is probably already in recession but autos, housing and services are holding us up for now. Our market indicators are still telling the same story. The yield curve is flattening but in the middle of its historic range, providing little guidance since we don’t know if it will invert prior to recession.

Credit spreads on the other hand are speaking loudly and clearly, moving considerably wider last week although junk bonds did manage to eke out a gain Friday. We are near a point where spreads have never been outside recession.

Valuations, despite the recent correction are still rich. Lastly, momentum still points to a deeper correction or bear market in stocks. Momentum is shifting to long term bonds and gold, a shift that may itself have implications for growth (and one I’ve been anticipating for a long time, probably too long).

I won’t go so far as to say that the Fed has no impact on the market. They are a participant too and a large one so they do have an impact. But it is a lot less than most people and certainly the Fed, presume.

Economies and markets are self-correcting to the extent they are allowed to adjust. Most of the government actions taken in recession, monetary and fiscal, are intended to round off the edges, to soften the blow so to speak.

With monetary policy where it is and not particularly effective in the best of times and the politicians about to battle over the debt limit – again – a recession right now would probably be the closest we’ve come in my lifetime to one with no safety net.

And I think the market would be just fine with that, would adjust and start creating the conditions for recovery even if the Fed and Congress are sidelined. We’d be a lot better off in the long run if we found out.

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An interesting side benefit of the Fed having pegged interest rates effectively to zero and having accomplished so little with QE, is that we get to see markets' self-correcting tendency.
markets, Fed, Congress, investing
Monday, 05 October 2015 11:24 AM
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