Don’t Sweat the Fed

by Daniel Putnam | January 31, 2014 9:36 am

As important as Federal Reserve policy has been for the markets in recent years, at this point it should a low priority on investors’ list of concerns.

That may sound like an outrageous assertion until you consider the question: What can the Fed actually do to surprise the markets?

The baseline expectation for Fed policy right now is that the central bank will wind down quantitative easing gradually and wrap up the program by October. This could go two ways: Either economic growth will slow somewhat and the Fed will drag out tapering longer than expected, or growth will pick up steam and bring about a more rapid end to tapering.

Either case presents a fairly favorable backdrop for the markets.

In reality, however, it would probably take extraordinary circumstances to prompt the Fed to deviate from its current course. And since the Fed is in a reactive mode (also known as being “data dependent”), the markets will see the impetus for a shift well before the central bank adjusts its policy.

For individual investors, this means that there’s little value in trying to handicap the Fed’s next move regarding QE — or paying too much attention to the type of noise that followed the Fed’s tapering announcement on Wednesday afternoon.

When Will the Fed Raise Rates?

Tapering isn’t the only issue making headlines, since the largest variable regarding Fed policy is the timing of its first increase in short-term interest rates.

Those who follow the financial media will have noticed a growing drumbeat of discussion about this topic in recent weeks, and the fed funds futures market shows that investors are factoring in the possibility of rate hikes — however modest — early in 2015. The CME website offers this page[1], which shows the probabilities of various levels for the fed funds rate on specific dates. As of Wednesday afternoon, the January 28, 2015, contract was showing a 19% chance that the Fed will have raised rates by that date. The odds of a Fed rate hike by various other dates in the contract series are show in the table below.

Contract Expiration Implied Odds of Fed Rate Hike (as of 1/30)
March 31, 2014 0%
January 28, 2015 19%
March 18, 2015 25%
April 29, 2015 39%
June 17, 2015 49%
July 29, 2015 65%
September 16, 2015 76%
October 31, 2015 89%

A 19% chance is fairly low on an absolute basis, and part of this number likely reflects hedging by fixed income managers. Still, these odds  seem too high, considering the Fed is clearly stating its intention to keep rates at their current 0-0.25% level well after quantitative easing is wrapped up. In its statement on Wednesday, the FOMC said the following: “The Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.”

If tapering is indeed wrapped up in October, as the current consensus projects, is three months really a “considerable time”?

The statement went on to say:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.

This isn’t the tone of a Fed that plans to take an aggressive approach to raising interest rates. Notably, the Fed intends to raise rates gradually even after it begins the process of normalizing policy. This means that even if the Fed did begin raising rates in January 2015, the fed funds rate probably wouldn’t be much above 1% by the end of next year … which isn’t exactly a level that would kneecap the equity markets.

The Expectations Game

This brings us back to the potential market impact of Fed policy. The Fed is erring on the side of caution with respect to tightening, which means that monetary policy isn’t a meaningful threat to market performance. For the Fed to take the risk of raising rates faster than the current timetable, it would need to see a substantial uptick in growth. This scenario in fact would be positive for the markets, on balance, since it would provide a much-needed boost to corporations’ top-line revenues.

Already, however, some cracks in this storyline are beginning to show: The 10-year Treasury yield dropped below 2.68% on Wednesday from the 3.03% level at which it entered the year. This downturn has occurred even with the backdrop of Fed tapering — indicating that the growth outlook may be less stellar than the professional optimists in the money-management industry would have us believe. The real threat to stock prices isn’t Fed rate hikes, but rather the potential for slower-than-expected growth — especially if the slowdown is the result of turmoil in China or elsewhere in the emerging markets.

Add it up, and there’s no reason to fear Fed policy right now.

If anything, market participants should be hoping that the Fed maintains its current track or takes an approach that’s slightly more aggressive than expected, because that’s far preferable to the alternative. The topic of Fed policy may make for good headlines, but it will do little to help investors’ bottom lines.

Endnotes:
  1. this page: http://www.cmegroup.com/trading/interest-rates/fed-funds.html

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