Weekend Commentary - Fed Moves ahead

Published on: 10:26AM Jul 13, 2014

www.thehueberreport.com/freetrial

Ever since the United States Federal Reserve embarked on a program of "extraordinary measures to meet extraordinary economic challenges"[1] there has been a debate as to how the economy and by extension markets will react once the artificial stimulus of Fed bond purchases and zero interest rates have ended.  The theory all along has been that we needed these drugs to keep what appeared to have been a terminal patient alive and allow time for it to recuperate.  Once the physicians at the Fed believed that the patient could enter rehab and eventually begin standing on its own, the weaning process could begin but the process would of course be gradual.  Not even counting the TARP bailout, realistically the economy has been propped up by a zero interest rate environment since 2009 and when it became evident that only stabilized the patient, the Quantitative Easing program was rolled out in late September 2012 to try and kick start a recovery. This eventually grew to government bond and mortgage-backed security purchases of $85 billion per month.  Talk about expensive health care! While spending money never assures that a patient will recover we can actually look back over thousands of years of economic history for verification that this kind of program will produce results, but never without side effects but more on that in a different letter.

We did begin the first phase of the weaning process back in January when the Fed initially cut the bond purchases by $10 billion per month and have done so each month since. According to the June FOMC meeting minutes they intend to completely end the QE program with a final purchase of $15 billion in October.  So far so good as with the exception of the negative GDP posted in the first quarter, the economy has limped forward, inflation has remained below target levels and even more important, the unemployment rate has continued to slip lower, reaching 6.1% in June.  It has been generally accepted that interest rates would not see any increase until the unemployment rate dipped below 6.2% and QE tapering was complete. With one of these benchmarks reached and the other in sight, speculation and debate have been increasing as to when that hike might be forthcoming and what the possible impact there may be on the economy and more specifically the daily measure of such that we refer to as equity markets.

Many, including a number of Fed board members have not expected to see interest rates  increase until late 2015 but with the overall improvements seen, a number of more moderate to hawkish members are openly discussing moving this up next year so we may be finding out sooner than later of what the impact will be. 

Realistically, a 25 basis point increase in the Fed Funds rate should have little impact on the overall business environment but psychologically, the effect of such could carry a greater weight than we might expect.  Just think of a few months ago when mortgage rates began to inch higher.  By historical standards, they remained extremely low but the increase quickly hit the refinance market as well as stagnated the recovery in real estate.  Additionally, once we have crossed that threshold, the expectation will be to see higher and higher rates over time, which should produce more uncertainty and ultimately more volatility in markets, which is something we have grown unaccustomed to.  After six years of absolutely flat zero percent interest rates too many have grown to believe this is a rational expectation and have developed business and valuation models or profiles to reflect this as the new norm.  Remember, there was a time that it was generally accepted that the growth in real estate values was just a part of the new economy and as such carried little risk.  Change is almost never pleasant for the unsuspecting and complacent.    

Ms. Yellen will be speaking in front of congress this coming week and you can be assured that market watchers will be hanging on her each and every word looking for any hint of when interest rates could begin moving higher.  I really doubt she will oblige anyone by announcing a date but the handwriting already appears to be on the wall and we should be looking for this to occur anytime after October this year. Once it begins, we shall find out if this patient will be able to walk on it own once again.