Home Markets Fine Tuning The Fed: Many Questions, Where Are The Answers?

Fine Tuning The Fed: Many Questions, Where Are The Answers?


Some time ago I gave up Fed Watching in favor of fish watching. Both are equally boring but at least you know the fish will always come to the source of food. The Fed is less predictable and beside, for the better part of the last five years, not much has been happening.

That is unless you ignore their first Fed induced interest rate increase in December 2015. Even though widely anticipated, the first increase in seven years sent the US equity markets into a tailspin. Yes, a quick recovery did begin in February of 2016. Today the S&P 500 and other market indices keep busting into record territory.

In a very real sense Janet Yellen and her Fed cohorts presented investors with an early Christmas present in 2015; one very big buying opportunity for stocks. Long live Her Majesty.

December 2015 and the early part of last year, however, marked the end of a bull market in bonds that dates back to the early years of the Reagan administration when short rates peaked out at more than 20% and when new issue 20 year AAA corporate bonds were priced in the 12%-13% range.

Just as the bad old days of high interest rates and inflation are behind, so is really cheap money. This is not startling news. Speculation of multiple rate increases in 2016 persisted throughout last year and indeed the Fed bumped rates again in December.

During much of this time, Fed members were divided on the need for higher rates. Several governors even spoke openly in disagreement with Fed Chair Yellen. The main issue was over how much monetary stimulus was possible before setting in motion a major new wave of inflation. Unemployment was falling but real wages were still in the doghouse, so there was precious little evidence of inflationary pressure.

Fast forward to February 22, 2017, minutes of the January FOMC meeting are released and now the opinion appears to be heavily favoring multiple rate increases this year. Well as least team Yellen is playing like a strong professional team (not to be mistaken for the Cleveland Browns).

If you read between the lines, we suspect the change of Fed mood has more to do with qualitative things like vibe, spirit, feeling and pure guessing that hard economic facts. The Fed feels the economy may not be falling victim to the same first quarter lull of the past two years. They gage the attitudes of business to be improving in anticipation of the new Trump administration plans for tax reform and other pro business policies.

Here is the bottom line question. The Fed has already made two rate increases that have been met with a surprisingly favorable stock market response. Interest rates and stock prices are negatively correlated. One goes up, the other goes down.

So far, this hasn’t happened, leading some investors to believe things are different this time around. That logic has killed more investors than the Black Plague. But when the news headlines tell a story of record stock market prices, it makes people feel well off and comfortable.

This question is made relevant by the most important mood indicator I know, the VIX Volatility Index. The index remains at a languid 10-12 area down almost 50% from election time levels last November. This is not normal. Optimism is a necessary ingredient for a health economy but blind optimism adds an element of risk. Is the Trump aura lulling everyone into a coma? With the stock market hitting new highs it is important to keep your eyes open.

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