Sunday, September 29, 2013

The invisible ruler of the Federal Reserve

The woes for many individual stocks began in August with the Fed’s intimation that the central bank would start “tapering” its $85 billion/month asset purchase program in September.  The warning turned out to be a “head fake” since the Fed kept the rate of purchases intact, but the cat was already out of the bag.  As we talked about in a previous commentary, the Fed’s threat to decrease the level of stimulus was tantamount to actually doing so.  Investors reacted by selling bonds and interest rate-sensitive stocks and the mortgage market felt the sting.  Tight money, in other words, became a reality as soon as certain Fed members started voicing their future intentions.

The question now becomes one of how much longer the Fed can keep the inevitable at bay.  Sooner or later they’ll be forced to scale back on bond buying and its hand will eventually be forced by the direction of short-term Treasury rates.   A colleague recently shares an insight with me concerning the Fed Funds Rate (FFR) and 3-month Treasury rates that’s worth repeating: 

“I’ve been thinking lately that Fed policy is like the Wizard of Oz on the big screen. Many believe in it and perception has become reality to an extent.  For one, the Fed Funds Rate is never raised in early stages of the bull is it?  Hmm, so they wait till the bull is rolling over and/or rates are rising (like the 3-month rate which the FFR absolutely HAS to follow – think this through!).  Then the Fed gets blamed for the downturn which raises the Fed’s power in the minds of the people.  That’s mental conditioning if you ask me.”

Indeed, the invisible ruler of the Federal Reserve is the market’s future expectations of inflation.  We saw this in 2004 when the 3-month Treasury yield began rising at the start of the year.  Then Fed Chairman Greenspan was forced to follow suit a few months later by raising the Fed Funds Rate, a trend which continued for the next three years and which contributed to the credit crisis.

We’re still likely a long way from when the 3-month Treasury yield begins rising enough to force the Fed to raise the FFR, but even so the consequences of an unsettled stock and bond market due to uncertainty over the Fed’s next move will provide more than enough headaches for investors.