“The real problem for the Fed is that it has completely abandoned any semblance to a systematic policy framework, in apparent preference for a purely discretionary one. By relentlessly depriving investors of risk-free return, the Federal Reserve has spawned an all-asset speculative bubble that we estimate will provide investors little but return-free risk.”
The chart below shows alternative systematic approaches to interest rate policy. Ever since 2008 the Fed has been far below alternative methodologies showing a clear bias. How the Fed continued to dismiss the clear inflation developments last year is an obvious discretionary error.
In the next few months the Fed will have to confront the downside of its discretionary excesses over the last few years.
The Fed is now wide open to criticism. It has implemented excessive stimulus for too long, and is now getting round to tightening policy far too late. Rather than smoothing out economic disturbances, the Fed will now be seen increasingly as the source of instability – creating the biggest bubble of the last 100 years, and now the highest rate of inflation for 40 years.
The Fed is now so late in addressing inflation, that it will be tightening policy just as the rate of change of both inflation and economic growth are likely to turn down. This economic environment is called Quad 4 .
The Fed may repeat its performance of Q4 2018. Back then the Fed was blind to Quad 4 conditions and tightened policy into a slowdown until the S&P 500 fell 20%. Only then did the Fed respond with a complete policy reversal.
Market indicators have begun to price in this confrontation. The two charts below demonstrate how limited the Fed’s abilities have become.
The excessive “stimulus” of economic policy has reached its limits with the explosion of inflation. Even worse the Fed still has stimulative policy in place! A CPI print of 7.5% while the Fed funds rate is near zero, and still stimulating the economy with QE, is embarrasing.
The Fed may feel forced to catch up with the timing and extent of interest rate hikes. However, the economy is already slowing and the Fed could easily create further instability by going too far too fast.
Years of excessive policy support have left the Fed with limited choices as shown below. Debt to GDP has more than doubled since 2008, and with it 30 real yields have fallen to well below zero, as the Fed has more than doubled its holdings of Treasuries. Investors need to consider TIPS if they are looking for positive real yields, but even there positive real yield have become increasingly scarce or fleeting
Also, the chart above shows how difficult it is for interest rates to rise too far. The level of debt is substantial. Not just Treasuries but corporate debt has grown substantially too, and with it, the average credit rating has declined making it highly fragile in a rising rate environment.
The Chart below shows that already the bond market is pricing in negative Fed fund forward interest rates, just as it did in 2018. The market in effect expects the Fed to go too far in its interest rate rises even before it starts. No wonder. Historically once the Fed starts to raise interest rates it continues to do so until it is clear it needs to stop. The Fed is reactive and too late in both directions.
What Does This Mean For Equities?
The equity market has also been distorted by Fed policy. QE since 2009 has a remarkably strong correlation to the S&P 500 index. From a valuation perspective based on data going back to 1928, what best correlates with the subsequent twelve year return suggests investors should expect on average a negative 6% return per annum over this period.
The real earnings yield of the S&P 500 is the lowest it has ever been.
The Fed has so supported the stock market with its policies that most investors have become dependent on its ability to continue doing so. Now it looks like the Fed has no choice other than a continuance of above target inflation or much higher interest rates. Neither of these options are supportive of the US equity market.
It is worth examining the experience of Q4 2018 as a guide for the current set up. There are differences of course. For example, the stimulus since 2018 has been enormous, the markets are higher and the debt is far greater.
Investors may need to consider the extent to which they believe that the Fed is capable of normalizing the situation, and “saving” the markets once again. It is also worth considering how closely investment portfolios match optimal Quad 4 allocation.