“I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”  – Alan Greenspan

Imagine if Federal Reserve (Fed) Chairman Jerome Powell told the American people they must pay more for the goods and services they consume.

How long would it take for mobs with pitchforks to surround the Mariner Eccles building?  However, Jerome Powell and every other member of the Fed routinely and consistently convey pro-inflationary ideals, and there is nary a protest, which seems odd. The reason for the American public’s complacency is that the Fed is not that direct and relies on carefully crafted language and euphemisms to describe the desire for higher inflation.

To wit, the following statements from past and present Fed officials make it all but clear they want more inflation:  

• “That is why it is essential that we at the Fed use our tools to make sure that we do not permit an unhealthy downward drift in inflation expectations and inflation,” – Jerome Powell November 2019
• “In order to move rates up, I would want to see inflation that’s persistent and that’s significant,” -Jerome Powell December 2019
• “Been very challenging to get inflation back to 2% target” -Jerome Powell December 2019
• “Ms. Yellen also said that continuing low inflation, regarded as a boon by many, could be “dangerous” – FT – November 2017
• “One way to increase the scope for monetary policy is to retain the Fed’s current focus on hitting a targeted value of inflation, but to raise the target to, say, 3 or 4 percent.” –Ben Bernanke October 2017
• “Further weakness in inflation could prompt the U.S. Federal Reserve to cut interest rates, even if economic growth maintains its momentum”  -James Bullard, President of the Federal Reserve Bank of St. Louis  May 2019
• “Fed Evans Says Low Inflation Readings Elevating His Concerns” -Bloomberg May 2019
• “I believe an aggressive policy action such as this is required to re-anchor inflation expectations at our target.”  Neel Kashkari, President Minneapolis Fed June 2019

As an aside, it cannot be overemphasized the policies touted in the quotes above actually result in deflation, an outcome the Fed desperately fears.

The Fed, and all central banks for that matter, have a long history of using confusing economic terminology. Economics is not as complicated as the Fed makes it seem. What does make economics hard to grasp is the technical language and numerous contradictions the Fed uses to explain economics and justify unorthodox monetary policy. It is made even more difficult when the Fed’s supporting cast – the media, Wall Street and other Fed apologists – regurgitate the Fed’s gibberish.   

The Fed’s fourth installment of quantitative easing (“QE4”, also known as “Not-QE QE”) is vehemently denied as QE by the Fed and Fed apologists. These denials, specifically a recent article in the Financial Times (FT), provide us yet another opportunity to show how the Fed and its minions so blatantly deceive the public.

What is QE?

QE is a transaction in which the Fed purchases assets, mainly U.S. Treasury securities and mortgage-backed-securities, via their network of primary dealers. In exchange for the assets, the Fed credits the participating dealers’ reserve account at the Fed, which is a fancy word for a place for dormant money. In this transaction, each dealer receives payment for the assets sold to the Fed in an account that is essentially the equivalent of a depository account with the Fed. Via QE, the Fed has created reserves that sit in accounts maintained by it.

Reserves are the amount of funds required by the Fed to be held by banks (which we are using interchangeably with “primary dealer” for the remainder of this discussion) in their Fed account or in vault cash to back up a percentage of specified deposit liabilities. While QE is not directly money printing, it enables banks to create loans at a multiple of approximately ten times the reserves available, if they so choose.

Notice that “Quantitative Easing” is the preferred terminology for the operations that create additional reserves, not something easier to understand and more direct like money/reserve printing, Fed bond buying program, or liquidity injections. Consider the two words used to describe this policy – Quantitative and Easing. Easing is an accurate descriptor of the Fed’s actions as it refers to an action that makes financial conditions easier, e.g., lower interest rates and more money/liquidity. However, what does quantitative mean? From the Oxford Dictionary, “quantitative” is “relating to, measuring, or measured by the quantity of something rather than its quality.”   

So, QE is a measure of the amount of easing in the economy. Does that make sense to you? Would the public be so complacent if QE were called BBMPO (bond buying and money printing operations)? Of course not. The public’s acceptance of QE without much thought is a victory for the Fed marketing and public relations departments.

Is “Not-QE” QE?

The Fed and media are vehemently defending the latest round of repurchase market (“repo”) operations and T-bill purchases as “not QE.” Before the Fed even implemented these new measures, Jerome Powell was quick to qualify their actions accordingly: “My colleagues and I will soon announce measures to add to the supply of reserves over time,” “This is not QE.”

This new round of easing is QE, QE4, to be specific. We dissect a recent article from the FT to debunk the nonsense commonly used to differentiate these recent actions from QE.  

On February 5^th, 2020, Dominic White, an economist with a research firm in London, wrote an article published by the FT entitled The Fed is not doing QE. Here’s why that matters.

The article presents three factors that must be present for an action to qualify as QE, and then it rationalizes why recent Fed operations are something else. Here are the requirements, per the article:

1. “increasing the volume of reserves in the banking system”
2. “altering the mix of assets held by investors”
3. “influence investors’ expectations about monetary policy”

Simply:

1.  providing banks the ability to make more money
2.  forcing investors to take more risk and thereby push asset prices higher
3.  steer expectations about future Fed policy. 

Point 1

In the article, White argues “that the US banking system has not multiplied up the Fed’s injection of reserves.”

That is an objectively false statement. Since September 2019, when repo and Treasury bill purchase operations started, the assets on the Fed’s balance sheet have increased by approximately $397 billion. Since they didn’t pay for those assets with cash, wampum, bitcoin, or physical currency, we know that $397 billion in additional reserves have been created. We also know that excess reserves, those reserves held above the minimum and therefore not required to backstop specified deposit liabilities, have increased by only $124 billion since September 2019. That means $273 billion (397-124) in reserves were employed (“multiplied up”) by banks to support loan growth.

Regardless of whether these reserves were used to back loans to individuals, corporations, hedge funds, or the U.S. government, banks increased the amount of debt outstanding and therefore the supply of money. In the first half of 2019, the M2 money supply rose at a 4.0% to 4.5% annualized rate. Since September, M2 has grown at a 7% annualized rate.  

Point 2

White’s second argument against the recent Fed action’s qualifying as QE is that, because the Fed is buying Treasury Bills and offering short term repo for this round of operations, they are not removing riskier assets like longer term Treasury notes and mortgage-backed securities from the market. As such, they are not causing investors to replace safe investments with riskier ones.  Ergo, not QE.

This too is false. Although by purchasing T-bills and offering repo the Fed has focused on the part of the bond market with little to no price risk, the Fed has removed a vast amount of assets in a short period. Out of necessity, investors need to replace those assets with other assets. There are now fewer non-risky assets available due to the Fed’s actions, thus replacement assets in aggregate must be riskier than those they replace.

Additionally, the Fed is offering repo funding to the market.  Repo is largely used by banks, hedge funds, and other investors to deploy leverage when buying financial assets. By cheapening the cost of this funding source and making it more readily available, institutional investors are incented to expand their use of leverage. As we know, this alters the pricing of all assets, be they stocks, bonds, or commodities.

By way of example, we know that two large mortgage REITs, AGNC and NLY, have dramatically increased the leverage they utilize to acquire mortgage related assets over the last few months. They fund and lever their portfolios in part with repo.

Point 3

White’s third point states, “the Fed is not using its balance sheet to guide expectations for interest rates.”

Again, patently false. One would have to be dangerously naïve to subscribe to White’s logic. As described below, recent measures by the Fed are gargantuan relative to steps they had taken over the prior 50 years. Are we to believe that more money, more leverage, and fewer assets in the fixed income universe is anything other than a signal that the Fed wants lower interest rates? Is the Fed taking these steps for more altruistic reasons?

Bad Advice

After pulling the wool over his reader’s eyes, the author of the FT article ends with a little advice to investors: “Rather than obsessing about fluctuations in the size of the Fed’s balance sheet, then, investors might be better off focusing on those things that have changed more fundamentally in recent months.”

After a riddled and generally incoherent explanation about why QE is not QE, White has the chutzpah to follow up with advice to disregard the actions of the world’s largest central bank and the crisis-type operations they are conducting. QE 4 and repo operations were a sudden and major reversal of policy. On a relative basis using a 6-month rate of change, it was the third largest liquidity injection to the U.S. financial system, exceeded only by actions taken following the 9/11 terror attacks and the 2008 financial crisis. As shown below, using a 12-month rate of change, recent Fed actions constitute the single biggest liquidity injection in 50 years of data.

Are we to believe that the latest round of Fed policy is not worth following? In what is the biggest “tell” that White is not qualified on this topic, every investment manager knows that money moves the markets and changes in liquidity, especially those driven by the central banks, are critically important to follow.

The graph below compares prior balance sheet actions to the latest round.

Data Courtesy St. Louis Federal Reserve

This next graph is a not so subtle reminder that the current use of repo is simply unprecedented.

Data Courtesy St. Louis Federal Reserve

Summary

This is a rebuttal to the FT article and comments from the Fed, others on Wall Street and those employed by the financial media. The wrong-headed views in the FT article largely parrot those of Ben Bernanke. This past January he stated the following:

“Quantitative easing works through two principal channels: by reducing the net supply of longer-term assets, which increases their prices and lower their yields; and by signaling policymakers’ intention to keep short rates low for an extended period. Both channels helped ease financial conditions in the post-crisis era.”   -LINK

Bourbon, tequila, and beer offer drinkers’ very different flavors of alcohol, but they all have the same effect. This round of QE may be a slightly different cocktail of policy action, but it is just as potent as QE 1, 2, and 3 and will equally intoxicate the market as much, if not more.

Keep in mind that QE 1, 2, and 3 were described as emergency policy actions designed to foster recovery from an economic crisis. Might that fact be the rationale for claiming this round of liquidity is far different from prior ones? Altering words to describe clear emergency policy actions is a calculated effort to normalize those actions. Normalizing them gives the Fed greater latitude to use them at will, which appears to be the true objective. Pathetic though it may be, it is the only rationale that helps us understand their obfuscation.

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

John Maynard Keynes – The Economic Consequences of Peace 1920

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.” –Jerome Powell January 29, 2020.

With that one seemingly innocuous statement, Chairman Powell revealed an alarming admission about the supply of money and your wealth. The current state of monetary policy explains why so many people are falling behind and why wealth inequality is at levels last seen almost 100 years ago. 

REALity

 “Real” is a very important concept in the field of economics. Real generally refers to an amount of something adjusted for the effects of inflation. This allows economists to measure true organic growth or decline.

Real is equally important for the rest of us. The size of our paycheck or bank account balance is meaningless without an understanding of what money can buy. For instance, an annual income of $25,000 in 1920 was about eight times the national average. Today that puts a family of four below the Federal Poverty Guideline. As your grandfather used to say, a dollar doesn’t go as far as it used to.

Real wealth and real wage growth are important for assessing your economic standing and that of the nation.

Here are two facts:

• Wealth is largely a function of the wages we earn
• The wages we earn are predominately a function of the growth rate of the economy

These facts establish that the prosperity and wealth of all citizens in aggregate is meaningfully tied to economic growth or the output of a nation. It makes perfect sense.

Now, let us consider inflation and the role it plays in determining our real wages and real wealth.

If the rate of inflation is less than the rate of wage growth over time, then our real wages are rising and our wealth is increasing. Conversely, if inflation rises at a pace faster than wages, wealth declines despite a larger paycheck and more money in the bank.

With that understanding of “real,” let’s discuss inflation.

What is Inflation?

Borrowing from an upcoming article, we describe inflation in the following way:

“One of the most pernicious of these issues in our “modern and sophisticated” intellectual age is that of inflation. Most people, when asked to define inflation, would say “rising prices” with no appreciation for the fact that price movements are an effect, not a cause. They are a symptom of monetary circumstances. Inflation defined is, in fact, a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The price of cars, cheeseburgers, movie tickets, and all the other goods and services we consume are chiefly based on supply and demand. Demand is a function of both our need and desire to own a good and, equally importantly, how much money we have. The amount of money we have in aggregate, known as money supply, is governed by the Federal Reserve. Therefore, the supply of money is a key component of demand and therefore a significant factor affecting prices.

With the linkage between the supply of money and inflation defined, let us revisit Powell’s recent revelation.

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.”

In plain English, Powell states that the supply of money is based on the demand for money and not the economic growth rate.  To clarify, one of the Fed’s largest liabilities currently are bank reserves. Banks are required to hold reserves for every loan they make. Therefore, they need reserves to create money to lend. Ergo, “demand for our liabilities,” as Powell states, actually means bank demand for the seed funding to create money and make loans.

The relationship between money supply and the demand for money may, in fact, be aligned with economic growth. If so, then the supply of money should rise with the economy. This occurs when debt is predominately employed to facilitate productive investments.

The problem occurs when money is demanded for consumption or speculation. For example:

• When hedge funds demand billions to leverage their trading activity
• When Apple, which has over $200 billion in cash, borrows money to buy back their stock  
• When you borrow money to buy a car, the size of the economy increases but not permanently as you are not likely to buy another car tomorrow and the next day

Now ask, should the supply of money increase because of those instances?

The relationship between the demand for money and economic activity boils down to what percentage of the debt taken on is productive and helps the economy and the populace grow versus what percentage is for speculation and consumption.

While there is no way to quantify how debt is used, we do know that speculative and consumptive debt has risen sharply and takes up a much larger percentage of all debt than in prior eras.  The glaring evidence is the sharp rise of debt to GDP.

Data Courtesy St. Louis Federal Reserve

If most of the debt were used productively, then the level of debt would drop relative to GDP. In other words, the debt would not only produce more economic growth but would also pay for itself.  The exact opposite is occurring as growth languishes despite record levels of debt accumulation.

The speculative markets provide further evidence. Without presenting the long list of asset valuations that stand at or near record levels, consider that since the last time the S&P 500 was fairly valued in 2009, it has grown 375%. Meanwhile, total U.S. Treasury debt outstanding is up by 105% from $11 trillion to $22.5 trillion and corporate debt is up 55% from $6.5 trillion to $10.1 trillion. Over that same period, nominal GDP has only grown 46% and Average Hourly Earnings by 29%.

When the money supply is increased for consumptive and speculative purposes, the Fed creates dissonance between our wages, wealth, and the rate of inflation. In other words, they generate excessive inflation and reduce our real wealth.  

If this is the case, why is the stated rate of inflation less than economic growth and wage growth?

The Wealth Scheme

This scheme works like all schemes by keeping the majority of people blind to what is truly occurring. To perpetuate such a scheme, the public must be convinced that inflation is low and their wealth is increasing.

In 2000, a brand new Ford Taurus SE sedan had an original MSRP of $18,935. The 2019 Ford Taurus SE has a starting price of $27,800.  Over the last 19 years, the base price of the Ford Taurus has risen by 2.05% a year or a total of 47%. According to the Bureau of Labor Statics (BLS), since the year 2000, the consumer price index for new vehicles has only risen by 0.08% a year and a total of 1.68% over the same period.

For another instance of how inflation is grossly underreported, we highlighted flaws in the reporting of housing prices in MMT Sounds Great in Theory But…  To wit: 

“Since then, inflation measures have been tortured, mangled, and abused to the point where it scarcely equates to the inflation that consumers deal with in reality. For example, home prices were substituted for “homeowners equivalent rent,” which was falling at the time, and lowered inflationary pressures, despite rising house prices.

Since 1998, homeowners equivalent rent has risen 72% while house prices, as measured by the Shiller U.S. National Home Price Index has almost doubled the rate at 136%. Needless to say, house prices, which currently comprise almost 25% of CPI, have been grossly under-accounted for. In fact, since 1998 CPI has been under-reported by .40% a year on average. Considering that official CPI has run at a 2.20% annual rate since 1998, .40% is a big misrepresentation, especially for just one line item.”

Those two obscene examples highlight that the government reported inflation is not the same inflation experienced by consumers. It is important to note that we are not breaking new ground with the assertion that the government reporting of inflation is low. As we have previously discussed, numerous private assessments quantify that the real inflation rate could easily be well above the average reported 2% rate. For example, Shadow Stats quantifies that inflation is running at 10% when one uses the official BLS formula from 1980.

Despite what we may sense and a multitude of private studies confirming that inflation is running greater than 2%, there are a multitude of other government-sponsored studies that argue inflation is actually over-stated. So, the battle is in the trenches, and the devil is in the details.

As defined earlier, inflation is “a disequilibrium between the amount of currency entering an economic system relative to the productive output of that same system.”

The following graph shows that the supply of money, measured by M2, has grown far more than the rate of economic growth (GDP) over the last 20 years.

Data St. Louis Federal Reserve

Since 2000, M2 has grown 234% while GDP has grown at half of that rate, 117%. Over the same period, the CPI price index has only grown by 53%. M2 implies an annualized inflation rate over the last 20 years of 6.22% which is three times that of CPI. 

Dampening perceived inflation is only part of the cover-up. The scheme is also perpetuated with other help from the government. The government borrows to boost temporary economic growth and help citizens on the margin. This further limits people’s ability to detect a significant decline in their standard of living.

As shown below, when one strips out the change in government debt (the actual increase in U.S. Treasury debt outstanding) from the change in GDP growth, the organic economy has shrunk for the better part of the last 20 years. 

Data St. Louis Federal Reserve

It doesn’t take an economist to know that a 6.22% inflation rate (based on M2) and decade long recession would force changes to our monetary policy and send those responsible to the guillotines. If someone suffering severe headaches is diagnosed with a brain tumor, the problem does not go away because the doctor uses white-out to cover up the tumor on the x-ray film.

Despite crystal clear evidence, the mirages of economic growth and low inflation prevent us from seeing reality.

Summary

Those engaging in speculative ventures with the benefit of cheap borrowing costs are thriving. Those whose livelihood and wealth are dependent on a paycheck are falling behind. For this large percentage of the population, their paychecks may be growing in line with the stated government inflation rate but not the true inflation rate they pay at the counter. They fall further behind day by day as shown below.

While this may be hard to prove using government inflation data, it is the reality. If you think otherwise, you may want to ask why a political outsider like Donald Trump won the election four years ago and why socialism and populism are surging in popularity. We doubt that it is because everyone thinks their wealth is increasing. To quote Bill Clinton’s 1992 campaign manager James Carville, “It’s the economy, stupid.”

That brings us back to Jerome Powell and the Fed. The U.S. economy is driven by millions of individuals making decisions in their own best interests. Prices are best determined by those millions of people based on supply and demand – that includes the price of money or interest rates. Any governmental interference with that natural mechanism is a recipe for inefficiency and quite often failure.

If monetary policy is to be set by a small number of people in a conference room in the Eccles Building in Washington, D.C. who think they know what is best for us based on flawed data, then they should prepare themselves for even more radical social and political movements than we have already seen.

“I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019

The recent quote above from Federal Reserve Chairman Jerome Powell is powerful, to say the least. We cannot remember a time in the last 30 years when a Fed Chairman has so clearly articulated such a strong desire for more inflation.

In particular, let’s dissect the bolded words in the quote for further clarification. 

• “Really Significant”– Powell is not only saying that the Fed will allow a substantial boost to inflation but does one better by adding the word “really.”
• “Persistent”– Unlike the prior few Fed Chairman who claimed to be vigilant towards inflation, Powell is clearly telling us that he will not react to inflation that is not only a “really significant” leap from current levels, but a rate that lasts for a while.
• “Even Consider”– The language he uses here conveys the seriousness of the Fed’s commitment. The rise in inflation must not only be “really significant” but also “persistent.” Powell is saying both conditions must be met before they will even discuss rate hikes. A significant rise in inflation but one they do not deem to be persistent will not suffice. Nor would a persistent move in inflation but one they do not measure as significant. Both conditions must be present together based on his language.

We are stunned by the choice of words Powell used to describe the Fed’s view on inflation. We are even more shocked that the markets and the media are ignoring it. Maybe, they are failing to focus on the three bolded sections.

In fact, what they probably think they heard was:

I think we would need to see a move up in inflation before we consider raising rates to address inflation concerns.

Such a statement is more in line with traditional Fed-speak. The other alternative is that Powell has altered his language in so many different ways over the past year that nobody seems to be paying attention to his words anymore. If so, he has lost credibility.

This article presents Treasury Inflation-Protected Securities (TIPS) as a hedge against Jerome Powell and the Fed getting what they want.

Inflation and Stable Prices – Apples and Oranges

Before a discussion on using TIPS as a way to protect your investments from the deleterious effects of inflation, we need to examine how the Fed gauges inflation and debunk the narrative that terms inflation and price stability as one and the same. Price data going back about 250 years, as shown below, shows the stark difference between inflation and price stability.  

Data Courtesy: Lawrence H. Officer and Samuel H. Williamson, ‘The Annual Consumer Price Index for the United States, 1774-Present

The orange line plots annual price changes before the Fed was established in 1913. As shown, prices were volatile year to year, but cumulative inflation over the entire 138 year period was negligible at 23% or .15% annualized. Dare we say prices were stable?

Compare that to the era after the Fed’s creation (represented by the blue line above). Annual inflation rates were less volatile but largely positive. The cumulative growth of prices has been an astonishing 2491% in the post-Fed area, which equates to 3.1% annually. There is nothing stable about such massive price inflation. 

Here is another graph to shed more light on price stability.

Stable prices should be defined as prices that are constant. In other words, a dollar today can purchase the same basket of goods that it did yesterday. Inflation must be near zero over longer periods for this to occur.

The Fed’s definition of stable denotes a consistent rate of annual inflation. Based on their actions and words, they have little regard for the destruction of a dollar’s purchasing power caused by a steady inflation rate. The Fed benefits from this linguistic imprecision because it allows for economic expansion via the accumulation of debt while their Congressional mandates are achieved. This is why the Fed wants to produce inflation. It reduces the amount of debt on an inflation-adjusted basis. The Fed wants inflation but disguises it under the banner of price stability.

With Federal deficits now topping $1 trillion and corporate debt and consumer debt and financial liabilities at all-time highs as a percentage of GDP, we must think about hedging our equity and fixed income portfolios in case the Fed gets more inflation than the 2% goal they consider stable.

Despite what the Fed leads us to believe, they have little control over the rate of inflation and they do not know how to accurately measure it. As occurred 50 years ago, they can easily lose control of prices.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS tremendous. Change can happen in a hurry, and the only way to protect yourself or profit from it is to anticipate it.

The rest of this article is for RIA Pro subscribers only. If you are not a subscriber and want to learn about the mechanics of TIPS and how they can protect you in an inflationary or deflationary environment, please SIGN UP HERE for a 30-day free trial.

“I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019

The recent quote above from Federal Reserve Chairman Jerome Powell is powerful, to say the least. We cannot remember a time in the last 30 years when a Fed Chairman has so clearly articulated such a strong desire for more inflation.

In particular, let’s dissect the bolded words in the quote for further clarification. 

• “Really Significant”– Powell is not only saying that the Fed will allow a substantial boost to inflation but does one better by adding the word “really.”
• “Persistent”– Unlike the prior few Fed Chairman who claimed to be vigilant towards inflation, Powell is clearly telling us that he will not react to inflation that is not only a “really significant” leap from current levels, but a rate that lasts for a while.
• “Even Consider”– The language he uses here conveys the seriousness of the Fed’s commitment. The rise in inflation must not only be “really significant” but also “persistent.” Powell is saying both conditions must be met before they will even discuss rate hikes. A significant rise in inflation but one they do not deem to be persistent will not suffice. Nor would a persistent move in inflation but one they do not measure as significant. Both conditions must be present together based on his language.

We are stunned by the choice of words Powell used to describe the Fed’s view on inflation. We are even more shocked that the markets and the media are ignoring it. Maybe, they are failing to focus on the three bolded sections.

In fact, what they probably think they heard was:

I think we would need to see a move up in inflation before we consider raising rates to address inflation concerns.

Such a statement is more in line with traditional Fed-speak. The other alternative is that Powell has altered his language in so many different ways over the past year that nobody seems to be paying attention to his words anymore. If so, he has lost credibility.

This article presents Treasury Inflation-Protected Securities (TIPS) as a hedge against Jerome Powell and the Fed getting what they want.

Inflation and Stable Prices – Apples and Oranges

Before a discussion on using TIPS as a way to protect your investments from the deleterious effects of inflation, we need to examine how the Fed gauges inflation and debunk the narrative that terms inflation and price stability as one and the same. Price data going back about 250 years, as shown below, shows the stark difference between inflation and price stability.  

Data Courtesy: Lawrence H. Officer and Samuel H. Williamson, ‘The Annual Consumer Price Index for the United States, 1774-Present

The orange line plots annual price changes before the Fed was established in 1913. As shown, prices were volatile year to year, but cumulative inflation over the entire 138 year period was negligible at 23% or .15% annualized. Dare we say prices were stable?

Compare that to the era after the Fed’s creation (represented by the blue line above). Annual inflation rates were less volatile but largely positive. The cumulative growth of prices has been an astonishing 2491% in the post-Fed area, which equates to 3.1% annually. There is nothing stable about such massive price inflation. 

Here is another graph to shed more light on price stability.

Stable prices should be defined as prices that are constant. In other words, a dollar today can purchase the same basket of goods that it did yesterday. Inflation must be near zero over longer periods for this to occur.

The Fed’s definition of stable denotes a consistent rate of annual inflation. Based on their actions and words, they have little regard for the destruction of a dollar’s purchasing power caused by a steady inflation rate. The Fed benefits from this linguistic imprecision because it allows for economic expansion via the accumulation of debt while their Congressional mandates are achieved. This is why the Fed wants to produce inflation. It reduces the amount of debt on an inflation-adjusted basis. The Fed wants inflation but disguises it under the banner of price stability.

With Federal deficits now topping $1 trillion and corporate debt and consumer debt and financial liabilities at all-time highs as a percentage of GDP, we must think about hedging our equity and fixed income portfolios in case the Fed gets more inflation than the 2% goal they consider stable.

Despite what the Fed leads us to believe, they have little control over the rate of inflation and they do not know how to accurately measure it. As occurred 50 years ago, they can easily lose control of prices.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS tremendous. Change can happen in a hurry, and the only way to protect yourself or profit from it is to anticipate it.

Part two of this article is for RIA Pro subscribers only. If you are not a subscriber and want to learn about the mechanics of TIPS and how they can protect you in an inflationary or deflationary environment, please SIGN UP HERE for a 30-day free trial.

TIPS Mechanics

Few investors truly understand the mechanics of TIPS, so let’s review the basics.

TIPS are debt securities issued by the U.S. government.  Like most U.S. Treasury securities, TIPS have a stated maturity and coupon. Unlike other securities, the principal value of TIPS adjust based on changes in the rate of inflation. The principal value can increase or decrease but will never fall below the bond’s initial par value. The semi-annual coupon on TIPS are a function of the yield of a like-maturity Treasury bond less the expected inflation rate over the life of the security, known as the break-even inflation rate.

The tables below compare the cash flows of a typical fixed coupon Treasury bond, referred to as a nominal coupon bond, and a TIPS bond to help further clarify.

The table above shows the cash flows that an investor pays and receives when purchasing a five-year bond with a fixed coupon of 4% a year. The investor initially invests $1,000 in the bond and in return receives $40 or 4% a year plus a return of the original investment ($1,000) at maturity. In our example, the annual return to the bondholder is 4%. While the price and yield of the security will change during the life of the bond, an investor holding the bond to maturity will be guaranteed the cash flows, as shown.

The TIPS table above shows the cash flows an investor pays and receives when purchasing a five-year TIPS bond with a fixed coupon of 2% a year. Like the fixed coupon bond, the investor initially pays $1,000 to purchase the bond. The similarities end here. Every six months the principal value adjusts for inflation. The coupon payment for each period is then calculated based on the new principal value (and not on the original par value. The principal value can adjust downward, but it cannot fall below the original value. This is an important safety feature that guarantees a minimum return equal to the coupon times the original principal value.  At maturity, the investor receives the final adjusted principal value, not the original principal value. Please note that if a TIPS is bought in the secondary market at a principal value exceeding its original value, the investor can lose the premium and returns can be negative in a deflationary environment.

In the hypothetical example above and excluding reinvestment of coupon payments, an investor in the nominal bond will receive $1,200 in cumulative cash flows over the life of the security. The TIPS investor would receive $1,209.12 in cumulative cash flows.

TIPS are a bet or a hedge on the breakeven inflation rate. If realized inflation over the life of a TIPS is less than the breakeven rate the investor earns a lower return than on a nominal Treasury bond with the same coupon rate. As shown in our example, if inflation is greater than the breakeven rate, then the TIPS investor earns a higher return than a nominal Treasury bond with the same coupon.

The following charts show the return profiles under various inflation scenarios, for the fixed coupon and TIPS examples used in the tables above.

The first graph shows the real (inflation-adjusted) coupon payments at various levels of inflation and deflation. In deflationary environments, both bonds provide positive real returns with the fixed coupon bond outperforming by the 2% breakeven rate. As inflation rises above the breakeven rate, the real return on the TIPS bond increasingly outperforms the fixed bond.

The next graph shows the nominal coupons of both bonds, assuming the investor holds them to maturity. The fixed bond earns the 4% coupon through all inflation scenarios. The TIPS bond earns a constant 2% coupon through all deflationary scenarios while the coupon rises in value as inflation increases. 

At any point in a TIPS life, investors may incur mark to market losses, and if the bonds are sold before maturity, this can result in a permanent loss. Any TIPS bond held from issuance to maturity will have a real positive gain assuming the coupon is above zero, the same is not true for a fixed rate bond.

Current environment

Various inflation surveys, as well as market-implied readings, suggest investors expect low levels of inflation to continue for at least the next ten years. The following graph provides a historical perspective on inflation trends and current long term inflation expectations as measured by 5, 10, and 20-year TIPS breakeven inflation rates.

Data Courtesy: St. Louis Federal Reserve (FRED)

The rate of inflation over the last 20 years, as measured by the consumer price index, has generally been decelerating. In other words, prices are rising but at a progressively slower pace.  Since 1985, the year over year change in inflation has averaged 2.6%, and since 2015, it has averaged 1.5%.

The market determined break-even inflation rate, or the differential between TIPS yields and like maturity fixed coupon yields, for the next 5, 10, and 20 years is currently 1.39%, 1.59%, and 1.65%, respectively. Inflation expectations for the next twenty years are consistent with the actual rate of inflation for the last ten years.

The Case For TIPS

While most forecasts are based on the past and therefore do not predict meaningful inflation, we must remain cognizant that since the Great Financial Crisis in 2008/09, the Federal Reserve (FED) and many other central banks have taken extraordinary monetary policy actions. The Fed lowered their targeted interest rates to zero while central banks in Japan and Europe have gone even further and introduced negative interest rates. Additionally, banks have sharply increased their balance sheets. These actions are being employed to incentivize additional borrowing to foster economic growth and boost inflation. More recently, as we are now seeing with a new round of QE, it appears the Fed is now using monetary policy to help facilitate trillion-dollar Federal deficits. 

Investors must be careful with the market’s assumption that the Fed’s efforts to stimulate inflation will lead to the same inflation rates of the past decade. Further, if “warranted”, a central bank can literally print money and hand it out to its citizens or directly fund the government. These alternative methods of monetary policy, deemed “helicopter money” by Ben Bernanke, would most likely cause prices to rise significantly.   

“Too much” inflation would be a detriment to the equity and bond markets. If inflation rates greater than three or four percent were to occur, a large majority of investors would pay dearly. Such circumstances would depreciate investor asset values and simultaneously reduce their purchasing power. With this double-edged sword in mind, TIPS should be considered by all investors.

The graph below, courtesy Doug Short and Advisor Perspectives, shows that equity valuations tend to be at their highest when inflation ranges between zero and two percent. Outside of that band, valuations are lower.  Currently, the market is making a big bet that valuations can remain near historical highs and inflation will remain in its recent range.

The worst case scenario for TIPS, as shown in the graphs, is a continuation of the inflation trends of yesterday. In those circumstances, TIPS would provide a return on par with or slightly less than comparable maturity nominal Treasury bonds. Investors also need to incorporate the opportunity cost of not allocating those funds towards stocks or riskier bonds should inflation remain subdued.

For those conservative investors sitting on excess cash, TIPS can be effectively employed as a surrogate to cash but with the added benefits of coupon payments and protection against the uncertainty of inflation.  In a worst case scenario, TIPS provide a return similar to those found on money market mutual funds. In the event of deflation and/or negative rates, TIPS should outperform these funds, which could easily experience negative returns.

Summary

Markets have a long history of assuming the future will be just like the past. Such assumptions and complacency work great until they don’t.  We do not profess to know when inflation may pick up in earnest, and we do not have a good economic explanation for what would cause that to happen. That being said, monetary policy around the world is managed by aggressive central bankers with strong and misplaced beliefs about the benefits of inflation. At some point, there is a greater than zero likelihood central bankers will be pushed to take actions that are truly inflationary. While the markets may initially cheer, the inevitable consequences may be dire for anyone not focused on preserving their purchasing power.

We urge you to focus on the forgotten leg of wealth, purchasing power. The opportunity costs of owning TIPS are minimal and the potential hedge value of TIPS is tremendous. Change can happen in a hurry, and the only way to protect and or profit from it is to anticipate it. As has been said, you cannot predict the future, but you can prepare for it.

We leave you with an important quote from our recent article- Warning, No Life Guards on Duty.

Another “lifeguard” is Daniel Oliver of Myrmikan Capital. In a recently published article entitled QE for the People, Oliver eloquently sums up the Fed’s policy situation this way:

“The new QE will take place near the end of a credit cycle, as overcapacity starts to bite and in a relatively steady interest rate environment. Corporate America is already choked with too much debt. As the economy sours, so too will the appetite for more debt. This coming QE, therefore, will go mostly toward government transfer payments to be used for consumption. This is the “QE for the people” for which leftwing economists and politicians have been clamoring. It is “Milton Friedman’s famous ‘helicopter drop’ of money.” The Fed wants inflation and now it’s going to get it, good and hard.”

Part one of this article can be found HERE.

President Trump recently nominated Judy Shelton to fill an open seat on the Federal Reserve Board. She was recently quoted by the Washington Post as follows: “(I) would lower rates as fast, as efficiently, and as expeditiously as possible.” From a political perspective there is no doubting that Shelton is conservative.

Janet Yellen, a Ph.D. economist from Brooklyn, New York, appointed by President Barack Obama, was the most liberal Fed Chairman in the last thirty years.

Despite what appears to be polar opposite political views, Mrs. Shelton and Mrs. Yellen have nearly identical approaches regarding their philosophy in prescribing monetary policy. Simply put, they are uber-liberal when it comes to monetary policy, making them consistent with past chairmen such as Ben Bernanke and Alan Greenspan and current chairman Jay Powell.

In fact, it was Fed Chairman Paul Volcker (1979 to 1987), a Democrat appointed by President Jimmy Carter, who last demonstrated a conservative approach towards monetary policy. During his term, Volcker defied presidential “advice” on multiple occasions and raised interest rates aggressively to choke off inflation. In the short-term, he harmed the markets and cooled economic activity. In the long run, his actions arrested double-digit inflation that was crippling the nation and laid the foundation for a 20-year economic expansion.

Today, there are no conservative monetary policy makers at the Fed. Since Volcker, the Fed has been run by self-described liberals and conservatives preaching easy money from the same pulpit. Their extraordinary policies of the last 20 years are based almost entirely on creating more debt to support the debt of yesteryear as well as economic and market activity today. These economic leaders show little to no regard for tomorrow and the consequences that arise from their policies. They are clearly focused on political expediency.

Different Roads but the Same Path –Government

Bernie Sanders, Alexandria Ocasio-Cortez, Elizabeth Warren, and a host of others from the left-wing of the Democrat party are pushing for more social spending. To support their platform they promote an economic policy called Modern Monetary Theory (MMT). Read HERE and HERE for our thoughts on MMT. 

In general, MMT would authorize the Fed to print money to support government spending with the intention of boosting economic activity. The idealized outcome of this scheme is greater prosperity for all U.S. citizens. The critical part of MMT is that it would enable the government to spend well beyond tax revenue yet not owe a dime.   

President Trump blamed the Fed for employing conservative monetary policy and limiting economic growth when he opined, “Frankly, if we didn’t have somebody that would raise interest rates and do quantitative tightening (Powell), we would have been at over 4 instead of a 3.1.” 

Since President Trump took office, U.S government debt has risen by approximately $1 trillion per year. The remainder of the post-financial crisis period saw increases in U.S. government debt outstanding of less than half that amount. Despite what appears to be polar opposite views on just about everything, under both Republican and Democratic leadership, Congress has not done anything to slow spending or even consider the unsustainable fiscal path we are on. The last time the government ran such exorbitant deficits while the economy was at full employment and growing was during the Lyndon B. Johnson administration. The inflationary mess it created were those that Fed Chairman Volcker was charged with cleaning up.

From the top down, the U.S. government is and has been stacked with fiscal policymakers who, despite their political leanings, are far too undisciplined on the fiscal front.

We frequently assume that a candidate of a certain political party has views corresponding with those traditionally associated with their party. However, in the realm of fiscal and monetary policy, any such distinctions have long since been abandoned.

TRUST

Now consider the current stance of Democratic and Republican fiscal and monetary policy within the TRUST framework. Government leaders are pushing for unprecedented doses of economic stimulus. Their secondary goal is to maximize growth via debt-driven spending. Such policies are fully supported by the Fed who keeps interest rates well below what would be considered normal. The primary goal of these policies is to retain power.

To keep interest rates lower than a healthy market would prescribe, the Fed prints money. When policy consistently leans toward lower than normal rates, as has been the case, the money supply rises. In the wake of the described Fed-Government partnership lies a currency declining in value. As discussed in prior articles, inflation, which damages the value of a currency, is always the result of monetary policy decisions.

If the value of a currency rests on its limited supply, are we now entering a phase where the value of the dollar will begin to get questioned? We don’t have a definitive answer but we know with 100% certainty that the damage is already done and the damage proposed by both political parties increases the odds that the almighty dollar will lose value, and with that, TRUST will erode. Recall the graph of the dollar’s declining purchasing power that we showed in Part 1.

Data Courtesy St. Louis Federal Reserve

Got Money? 

If the value of the dollar and other fiat currencies are under liberal monetary and fiscal policy assault and at risk of losing the valued TRUST on which they are 100% dependent, we must consider protective measures for our hard-earned wealth.

With an underlying appreciation of the TRUST supporting our dollars, the definition of terms becomes critically important. What, precisely, is the difference between currency and money? 

Gold is defined as natural element number 79 on the periodic table, but what interests us is not its definition but its use. Although gold is and has been used for many things, its chief purpose throughout the 5,000-year history of civilization has been as money.

In testimony to Congress on December 18, 1912, J.P. Morgan stated: “Money is gold, and nothing else.” Notably, what he intentionally did not say was money is the dollar or the pound sterling. What his statement reveals, which has long since been forgotten, is that people are paid for their labor through a process that is the backbone of our capitalist society. “Money,” properly defined, is a store of labor and only gold is money.

In the same way that cut glass or cubic zirconium may be made to look like diamonds and offer the appearance of wealth, they are not diamonds and are not valued as such. What we commonly confuse for money today – dollars, yen, euro, pounds – are money-substitutes. Under an evolution of legal tender laws since 1933, global fiat currencies have displaced the use of gold as currency. Banker-generated currencies like the dollar and euro are not based on expended labor; they are based on credit. In other words, they do not rely on labor and time to produce anything. Unlike the efforts required to mine gold from the ground, currencies are nearly costless to produce and are purely backed by a promise to deliver value in exchange for labor.

Merchants and workers are willing to accept paper currency in exchange for their goods and services in part because they are required by law to do so. We must TRUST that we are being compensated in a paper currency that will be equally TRUSTed by others, domestically, and internationally. But, unlike money, credit includes the uncertainty of “value” and repayment.

Currency is a bank liability which explains why failing banks with large loan losses are not able to fully redeem the savings of those who have their currency deposited there. Gold does not have that risk as there is no intermediary between it and value (i.e., the U.S. government or the Japanese government). Gold is money and harbors none of these risks, while currency is credit. Said again for emphasis, only gold is money, currency is credit.

There is a reason gold has been the money of choice for the entirety of civilization. The last 90 years is the exception and not the rule.

Despite their actions and words, the value of gold, and disTRUST of the dollar is not lost on Central Bankers. Since 2013, global central banks have bought $140 billion of gold and sold $130 billion of U.S. Treasury bonds. Might we say they are trading TRUST for surety?

Summary

To repeat, currency, whether dollars, pounds, or wampum, are based on nothing more than TRUST. Gold and its 5000 year history as money represents a dependable store of labor and real value; TRUST is not required to hold gold. No currency in the history of humankind, the almighty U.S. dollar included, can boast of the same track record.

TRUST hinges on decision makers who are people of character and integrity and willingness to do what is best for the nation, not the few. Currently, both political parties are taking actions that destroy TRUST to gain votes. While political party narratives are worlds apart, their actions are similar. Deficits do matter because as they accumulate, TRUST withers.

This article is not a call to action to trade all of your currency for gold, but we TRUST this article provokes you to think more about what money is.

“I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.” He then stated: “In no sense is this QE.” –Federal Reserve Chairman Jerome Powell 10/8/2019

Jerome Powell can call balance sheet growth whatever he wants, but operationally and in its effect on the bond markets, it is QE. For more on the Fed’s latest iteration of QE, what we dub the non-QE QE, please read our article QE By Any Other Name.

Non-QE = QE4

It is increasingly likely the Fed will announce an asset purchase operation at the FOMC meeting on October 30, 2019. Given Powell’s comments, the asset purchases will differ somewhat from QE 1, 2, and 3 in that the Fed will add needed reserves to the banking system to help alleviate recent bouts of stress in overnight funding markets. Prior versions of QE added excess reserves to the system as a byproduct. The true benefit of prior rounds of QE was the reduction of Treasury and mortgage-backed securities in the marketplace, which pushed investors into riskier stocks and bonds.  

Since the Feds motivation seems to be stress in the short term funding markets, we believe the Fed will purchase short-term notes and Treasury bills instead of longer-term bonds. QE1 also involved the purchase the short term securities, but these securities were later sold and the proceeds used to purchase longer term bonds, in what was called Operation Twist.

Trading Non QE QE4

In Profiting From a Steepening Yield Curve and in a subsequent update to the article, we presented two high dividend stocks (AGNC and NLY) that should benefit from a steeper yield curve. When we wrote the articles, we did not anticipate another round of QE, at least not this soon. Our premise behind these investments was weakening economic growth, the likelihood the Fed would cut rates aggressively, and thus a steepening yield curve as a result.

The Fed has since cut rates twice, and Wall Street expects them to cut another 25bps at the October 30th meeting and more in future meetings. This new round of proposed QE further bolsters our confidence in this trade.

If the Fed purchases shorter-term securities, the removal of at least $200 to $300 billion, as is being touted in the media, should push the front end of the curve lower in yield. Short end-based QE in conjunction with the Fed cutting rates will most certainly reduce front-end yields. The rate cuts combined with QE will likely prevent long term yields from falling as much as they would have otherwise. On balance, we expect the combination of QE and further rate cuts to result in a steeper yield curve.

The following graph shows how the 10yr/2yr Treasury yield curve steepened sharply after all three rounds of QE were initiated. In prior QE episodes, the yield curve steepened by 112 basis points on average to its peak steepness in each episode.  

Data Courtesy: Federal Reserve

New Trade Idea

In addition to our current holdings (AGNC/NLY), we have a new recommendation involving a long/short bond ETF strategy. The correlation of performance and shape of the yield curve of this trade will likely be similar to the AGNC/NLY trade, but it should exhibit less volatility.

Equity long/short trades typically involve equal dollar purchases and sales of the respective securities, although sometimes they are also weighted by beta or volatility. Yield curve trades are similar in that they should be dollar-weighted, but they must also be weighted for the bond’s respective durations to account for volatility. This is because the price change of a two-year note is different than that of a 5 or 10-year note for the same change in yield, a concept called duration. Failing to properly duration weight a yield curve trade will not provide the expected gains and losses for given changes in the shape of the yield curve. 

Before presenting the trade, it is important to note that the purest way to trade the yield curve is with Treasury bonds or Treasury bond futures. Once derivative instruments, like the ETFs we discuss, are introduced, other factors such as fees, dividends, and ETF rebalancing will affect performance.  

The duration for SHY and IEF is 2.17 and 7.63, respectively. The ratio of the price of SHY to IEF is .74. The trade ratio of SHY shares to IEF shares is accordingly 4.75 as follows: [(1/.74)*(7.63/2.17)]. As such one who wishes to follow our guidance should buy 5 shares for every 1 share of IEF that they short.

Because we cannot buy fractions of shares, we rounded up the ratio to 5:1. This slight overweighting of SHY reflects our confidence that the short end of the yield curve will fall as the Fed operates as we expect.

Summary

In Investors Are Grossly Underestimating the Fed, we highlighted that every time the Fed has raised and lowered rates, the market has underestimated their actions. To wit:

“If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.”

Despite the Fed’s guidance earlier this year of one or two cuts and their characterization of it as a “mid-cycle adjustment”, the Fed has already lowered rates twice and appears ready to cut rates a third time later this month. If, in fact, the market is once again underestimating the Fed, the Fed Funds rate and short term Treasury yields will ultimately fall to 1% or lower.

In an environment of QE and the Fed actively lowering rates, we suspect the yield curve will steepen. That is in no small part their objective, as a steeper yield curve also provides much needed aid to their constituents, the banks. If we are correct that the curve steepens, the long-short trade discussed above along with AGNC and NLY should perform admirably.  AGNC and NLY are much more volatile than IEF and SHY; as such, this new recommendation is for more risk-averse traders.  

On July 1st, Michael Lebowitz was interviewed by Real Vision TV. In the interview he discussed our thoughts on the yield curve, corporate bonds, recession odds, the Federal Reserve, and much more. In particular, Michael pitched our recent portfolio transactions NLY and AGNC, which were both discussed in the following RIA PRO article: Profiting From a Steepening Yield Curve.

Real Vision was kind enough to allow us to share their exclusive video with RIA Pro clients. We hope you enjoy it.

To watch the Video please click HERE

 If you think the Fed may only lower rates by .50 or even .75, you may be grossly underestimating them.  The following article was posted for RIA Pro subscribers two weeks ago.

For more research like this as well as daily commentary, investment ideas, portfolios, scanning and analysis tools, and our new 401K manager sign up today at RIA Pro and test drive our site for 30 days before being charged.

---

Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.

The prospect of three 25 basis point rate cuts is hard to grasp given that the unemployment rate is at 50-year lows, economic growth has begun to slow only after a period of above-average growth, and inflation remains near the Fed’s 2% goal.  Interest rate markets are looking ahead and collectively expressing deep concerns based on slowing global growth, trade wars, and diminishing fiscal stimulus that propelled the economy over the past two years. Meanwhile, credit spreads and stock market prices imply a recession is not in the cards.

To make sense of the implications stemming from the Fed Funds futures market, it is helpful to assess how well the Fed Funds futures market has predicted Fed Funds rates historically. With this analysis, we can hopefully avoid getting caught flat-footed if the Fed not only lowers rates but lowers them more aggressively than the market implies.

Fed Funds vs. Fed Funds Futures

Before moving ahead, let’s define Fed Funds futures. The futures contracts traded on the Chicago Mercantile Exchange (CME), reflect the daily average Fed Funds interest rate that traders, speculator, and hedgers think will occur for specific one calendar month periods in the future. For instance, the August 2019 contract, trades at 2.03%, implying the market’s belief that the Fed Funds rate will be .37% lower than the current 2.40 % Fed Funds rate. For pricing on all Fed Funds futures contracts, click here.

To analyze the predictive power of Fed Funds futures, we compared the Fed Funds rate in certain months to what was implied by the futures contract for that month six months earlier. The following example helps clarify this concept. The Fed Funds rate averaged 2.39% in May. Six months ago, the May 2019 Fed Funds future contract traded at 2.50%. Therefore, six months ago, the market overestimated the Fed Funds rate for May 2019 by .11%. As an aside, the difference is likely due to the recent change in the Fed’s IOER rate.

It is important to mention that we were surprised by the conclusions drawn from our long term analysis of Fed Funds futures against the prevailing Fed Funds rate in the future.

The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.

To further help you understand the analysis we provide two additional graphs below, covering the most recent periods when the Fed was increasing and decreasing the Fed Funds rate.

Data Courtesy Bloomberg

Data Courtesy Bloomberg

Looking at the 2004-2006 rate hike cycle above, we see that the market consistently underestimated (red bars) the pace of Fed Funds rate increases.

Data Courtesy Bloomberg

During the 2007-2009 rate cut cycle, the market consistently thought Fed Funds rates would be higher (green bars) than what truly prevailed.

As shown in the graphs above, the market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.

Summary

If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?

We remind you that equity valuations are at or near record highs, in many cases surpassing those of the roaring 1920s and butting up against those of the late 1990s. If the Fed needs to cut rates aggressively, it will likely be the result of an economy that is heading into an imminent recession if not already in recession. With the double-digit earnings growth trajectory currently implied by equity valuations, a recession would prove extremely damaging to stock prices.

Treasury yields have fallen sharply recently across the entire curve. If the Fed lowers rates and is more aggressive than anyone believes, the likelihood of much lower rates and generous price appreciation for high-quality bondholders should not be underestimated.

The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.

As a portfolio manager and fiduciary, it is vital that we constantly assess the risks to our market and economic forecasts. To better quantify risk we must frequently go a step further and understand where the markets may be neglecting to appreciate risk. While tricky, those that properly detect when the market is offside tend to either protect themselves and/or profit handsomely. It is with contrarian glasses on that we look beyond July 4th and towards July 31st for fireworks.

Through June the stock and bond markets priced in, with near certainty, a 50 basis point rate cut at the July 31, 2019, Federal Reserve FOMC meeting. In doing so, volatility in many markets could surge if the Fed does not follow the market’s lead.

Given this concern, we ask what might cause the Fed to disappoint the markets. We approach the answer from two angles, economic and political.

Economic

On the economic front, there are a growing number of indicators that point to slowing domestic economic growth. The following graph from Arbor shows seven important leading indicators (surveys and outlooks).

While the graph is concerning, hard economic data which tends to lag the survey data graphed above has yet to weaken to the same degree. If the weakening in the indicators graphed above prove to be a false signal or transitory, the Fed might cut rates less than expected or even delay taking policy actions.

A second reason the Fed might delay or not take action would be an increase in inflation expectations. The Fed has been outspoken about the need to bolster inflation expectations which have recently drifted lower. Given that unemployment is at 50 years lows and inflation close to their target, inflation expectations seems to be the rationale the Fed is using to justify action. If inflation expectations were to increase the Fed may not be able to defend reducing rates. The following events could temporarily increase inflation expectations:

• Weaker dollar due to perceived easy monetary policy.
• Iran tensions could push oil prices higher.
• Excessive weather conditions in the Midwest are affecting consumer prices for certain commodities.
• Tariffs are likely to increase prices paid by businesses and consumers.
• Fed independence compromised (as discussed in the following paragraph).

Political

Beyond economics, politics is playing a role in the Fed’s thought process. The Fed was set up as an independent organization to insulate monetary policy from the often self-serving demands of the executive and legislative branches. Despite the Fed’s independence, many Presidents have bullied the Fed to take policy actions. Such tactics always occurred behind closed doors with the media and public having little idea that they were occurring.

Currently, President Trump is taking his criticism to the public airways and has gone as far as threatening to demote or fire Chairman Powell. A Fed Chairman has never been fired or demoted, leading many to question whether Trump has the legal authority to do so. The Federal Reserve Act states that the Chairman shall serve his stated term “unless sooner removed for cause by the President.” That sentence opens the door to much uncertainty under this President. The language is even less vague about demotion, which, in our opinion, is more likely.

If the Fed wants to assert its independence from the executive branch, they may be inclined to cut by 25 basis points or possibly not cut at all.  Anything short of a 50 basis point rate cut would inevitably irritate the President and increase the risk that Trump fires or demotes Powell. If such an unprecedented action were to transpire the markets would likely react violently. For more on how certain asset classes might perform in this scenario, please read our article Market Implications for Removing Fed Chair Powell.

Beyond the initial market responses to the news, a greater problem could arise. The peril of openly piercing the veil of independence at the Fed could impair many of the communication tools the Fed uses to influence policy and markets. In turn, the Fed will be limited in their ability to coax or pacify markets when needed.

While this spat may be brushed off as Beltway politics aired for the public in the Twittersphere and media, the consequences are large, and as such we must pay attention to this political soap opera.

Summary

We believe a 50 basis point cut is likely on July 31^st and afterward the markets will renew their focus on the next few months and what that may have in store. However, unlike the vast majority, we believe that there are factors that may cause the Fed to sit on their hands. If the Fed disappoints the market, especially if not accompanied by warnings, the July fireworks this year may be coming 27 days late.

Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.

The prospect of three 25 basis point rate cuts is hard to grasp given that the unemployment rate is at 50-year lows, economic growth has begun to slow only after a period of above-average growth, and inflation remains near the Fed’s 2% goal.  Interest rate markets are looking ahead and collectively expressing deep concerns based on slowing global growth, trade wars, and diminishing fiscal stimulus that propelled the economy over the past two years. Meanwhile, credit spreads and stock market prices imply a recession is not in the cards.

To make sense of the implications stemming from the Fed Funds futures market, it is helpful to assess how well the Fed Funds futures market has predicted Fed Funds rates historically. With this analysis, we can hopefully avoid getting caught flat-footed if the Fed not only lowers rates but lowers them more aggressively than the market implies.

Fed Funds vs. Fed Funds Futures

Before moving ahead, let’s define Fed Funds futures. The futures contracts traded on the Chicago Mercantile Exchange (CME), reflect the daily average Fed Funds interest rate that traders, speculator, and hedgers think will occur for specific one calendar month periods in the future. For instance, the August 2019 contract, trades at 2.03%, implying the market’s belief that the Fed Funds rate will be .37% lower than the current 2.40 % Fed Funds rate. For pricing on all Fed Funds futures contracts, click here.

To analyze the predictive power of Fed Funds futures, we compared the Fed Funds rate in certain months to what was implied by the futures contract for that month six months earlier. The following example helps clarify this concept. The Fed Funds rate averaged 2.39% in May. Six months ago, the May 2019 Fed Funds future contract traded at 2.50%. Therefore, six months ago, the market overestimated the Fed Funds rate for May 2019 by .11%. As an aside, the difference is likely due to the recent change in the Fed’s IOER rate.

It is important to mention that we were surprised by the conclusions drawn from our long term analysis of Fed Funds futures against the prevailing Fed Funds rate in the future.

The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.

To further help you understand the analysis we provide two additional graphs below, covering the most recent periods when the Fed was increasing and decreasing the Fed Funds rate.

Data Courtesy Bloomberg

Data Courtesy Bloomberg

Looking at the 2004-2006 rate hike cycle above, we see that the market consistently underestimated (red bars) the pace of Fed Funds rate increases.

Data Courtesy Bloomberg

During the 2007-2009 rate cut cycle, the market consistently thought Fed Funds rates would be higher (green bars) than what truly prevailed.

As shown in the graphs above, the market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.

Summary

If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?

We remind you that equity valuations are at or near record highs, in many cases surpassing those of the roaring 1920s and butting up against those of the late 1990s. If the Fed needs to cut rates aggressively, it will likely be the result of an economy that is heading into an imminent recession if not already in recession. With the double-digit earnings growth trajectory currently implied by equity valuations, a recession would prove extremely damaging to stock prices.

Treasury yields have fallen sharply recently across the entire curve. If the Fed lowers rates and is more aggressive than anyone believes, the likelihood of much lower rates and generous price appreciation for high-quality bondholders should not be underestimated.

The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.

In the months leading up to the Presidential election of 1992, Bill Clinton advisor James Carville coined the phrase “It’s The Economy Stupid” as a rallying cry for his candidate. At the time the U.S. economy was mired in weak economic growth despite having recently emerged from a recession. Democratic hopeful Bill Clinton was quick to remind voters of the circumstance and place direct blame on his opponent, George H.W. Bush. The strategy James Carville and Bill Clinton employed focused on the fact that presidential incumbents fare poorly when the economy is suffering.

“Long in the tooth” and “bottom of the ninth inning” are phrases we have recently used to describe the current economic cycle. In just a matter of days, this economic expansion will tie the period spanning 1991-2001 as the longest era of uninterrupted growth since at least 1857.  

Whether the current expansion ends with a recession starting next week, next month or next year is unknown. What is known is that the odds of a recession occurring before the presidential election in a year and a half are reasonably high. As evidenced by public Fed-bashing for raising interest rates, this point is clearly understood by President Trump. 

Boosting Growth Beyond Its Natural Bounds

Donald Trump can certainly win reelection, but his chances are greatly improved if he avoids a recession and keeps the stock market humming along. Accomplishing this is not an easy task for several reasons as we expand on.

Trend Economic Growth

The natural growth rate of the economy is about 2% per annum and declining. The graph below shows the ten-year average growth rate and its trend over the last 60 years.

Data Courtesy: St. Louis Federal Reserve

The slope of the trend line is -0.0336x, meaning that trend growth is expected to decline further by 0.0336% per year or approximately 0.34% per decade.

Fiscal Stimulus

During Trump’s term, economic growth has run 0.50-0.75% above trend in large part due to various forms of fiscal stimulus, including tax reform, hurricane/fire relief, and increased deficit spending. In 2018 for example, Treasury debt outstanding increased by $1.48 trillion as compared to an increase of $515 billion in the prior year. The difference of nearly $1 trillion directly boosted GDP for 2018 by approximately 1.30%.

Even if the Treasury’s net spending were to increase by another $1.48 trillion this year, the incremental contribution to GDP growth for 2019 would be zero. Any decline in Treasury spending from prior year levels will reduce economic growth.  It is a story for another day, but most economic measures are centered on percentage growth rates and not absolute dollars, meaning what matters most is the rate and direction of change.  

Given that control of the House of Representatives is in Democratic control we find it unlikely that deficits can increase markedly from current levels. Simply, the Democrats will not do anything to boost the economy and help Trump’s election chances.

Monetary Stimulus

Without the help of fiscal stimulus and a low rate of natural economic growth, Trump’s best hope to sustain 3-4% economic growth and avoid a recession by 2020 is for the Fed to lower interest rates and quite possibly re-introduce QE. Trump and his economic team have been publically insistent that the Fed does just that. Consider the following clips from the media:

3/29/2019 – White House economic advisor Larry Kudlow says he wants the Fed to cut its overnight lending rate by 50 basis points “immediately.”

4/5/2019 – (Reuters) – “I think they should drop rates,” Trump told reporters. “I think they really slowed us down. There’s no inflation.”  The U.S. president also suggested that the central bank pursue an unconventional monetary policy called “quantitative easing” that was used to nurse the economy back after the global financial crisis. “It should actually now be quantitative easing,” Trump said.

3/26/2019 – Stephen Moore, Donald Trump’s nominee for a seat on the Federal Reserve Board, told the New York Times that the central bank should immediately reverse course and lower interest rates by half a percentage point.

4/14/2019

The Fed has partially acquiesced to Trump’s public demands. Over the last three months, the Fed has gone from a steadfast policy of further rate hikes and QT on “autopilot,” to ending the prospect of interest rate increases this year and halting QT by the end of the third quarter.

As far as the next step, reducing rates and possibly reengaging in QE, the Fed does not seem willing to do anything further. Consider the following clips from the media:

3/27/2019 – “I doubt we’re accommodative, but I also doubt we’re restrictive,” said Dallas Fed President Robert Kaplan. “If we’re restrictive, it is very modest.”

4/12/2019 – Minneapolis Fed President Neel Kashkari says it isn’t time to cut rates.

3/20/2019 – Per the FOMC statement from the most recent meeting- The Fed expects the benchmark rate to stay near 2.4 percent by the end of 2019.

4/11/2019 – “We’re strictly nonpartisan” “We check our political identification at the door” -Jerome Powell

4/12/2019 – Per Bond Buyer: Powell said to tell Democrats Fed won’t bend to pressure.

Based on the statements above and others, the Fed appears comfortable that their current policy is appropriate. It does not seem likely at this time that they will “bend to pressure” to get Trump and his team off their backs. 

Summary

Given that fiscal stimulus and the anemic growth trend will do little to help Donald Trump win reelection, all eyes should focus on the Fed. Pressure on the Fed to lower rates and start back up QE will become much stronger if the economy slows further and/or the stock market declines.

We believe the Fed will try to protect its perceived independence and keep policy tighter than the President and his team prefers. This dynamic between the President wanting a stronger economy to help his election chances and a Fed focused on maintaining their independence is likely to fuel fireworks on a scale rarely if ever seen in public. The market implications of such a publically waged battle should not be ignored.

This article is a prelude to another following soon which discusses the investment implications and consequences if Donald Trump were to fire or replace Chairman Powell.

Just in case you are wondering we believe the President can fire the Chairman despite no historical precedence for such an action. The paragraph below is from the Federal Reserve Act.

Shortly following the Fed meeting On January 30^th, we published a summary and thoughts of the Federal Reserve’s monetary policy meeting and Chairman Powell’s press conference. The market and our opinions seem to be aligned with a strong sense that the Fed was bowing to the pressure of the stock market and pivoting to a dovish tack. The following are the article’s four main takeaways:

• The Fed will be “patient” with future rate hikes, meaning they are now likely on hold as opposed to their forecasts which still call for two to three more rate hikes this year.
• The pace of QT or balance sheet reduction will not be on “autopilot” but instead driven by the current economic situation and tone of the financial markets.
• QE is a tool that will be employed when rate reductions are not enough to stimulate growth and calm jittery financial markets.
• The predominant rationale for the abrupt change in tone and possibly policy was the recent stock market weakness as well as pressure put upon the Fed by the President and the banking sector.

Having had more time to digest the statement and press conference and read other opinions, we introduce a few questions for your consideration.

What Does the Fed Know?

During the press conference, the Chairman was asked what has transpired since the last meeting on December 19, 2019, to warrant such an abrupt change in policy given that he recently stated that policy was accommodative, and the economy did not require such policy anymore. In response, Powell stated “We think our policy stance is appropriate right now. We do. We also know that our policy rate is now in the range of the committee’s estimates of neutral.” As we discussed in the original article, Powell’s response was incomplete and failed to address the question directly. Given his weak answer, we wonder if Powell knows something we don’t. Could China’s economy be rolling over at a much more concerning pace than anyone thinks? Are trade discussions with China a no-go, therefore resulting in eminent tariffs? Is a bank in trouble?

The possibilities are endless, but given Powell’s awkward response and unsatisfactory rationale to a simple and obvious question, it is possible that he is hiding something that accounts for the policy U-turn.

Has Powell Learned the Art of Politics?

The Fed is most likely aware that if a recession were to occur, their main lever for stimulating economic activity, interest rate reductions, will have little value. Given the amount of debt outstanding and the onerous burden of servicing it, the marginal benefit of lower rates will likely not provide enough benefits to lift the country out of a recession. In such a tough situation the next lever at their disposal is increasing their balance sheet and flooding the markets with liquidity via QE.

After increasing their balance fivefold during and shortly after the financial crisis, the Fed has finally begun reducing it (QT). Despite monthly reductions, currently in the $50 billion range, the balance sheet still stands at $4.05 trillion, over $3.1 trillion greater than where it stood on the eve of QE1 in 2008.

So, might Powell be taking a dovish tone to placate the markets, the President and his member banks and concurrently buying time to further normalize the balance sheet? This approach is like pouring liquid out of your cup so you can add more when the time is right. You would do this because it is not clear just how much “the cup” will ultimately hold. Bernanke and Yellen have both acknowledged that they were aware that each successive round of QE was somewhat less effective than prior rounds. That certainly must be a concern for Powell if he is called upon to re-engage QE in a recession or another economic crisis.

If this is the case, Powell will continue to publically discuss minimizing reductions to the balance sheet and refrain from further rate hikes. Despite such dovish Fed-speak, he would continue to shrink the balance sheet at the current pace. This tactic may trick investors for a few months but at some point, the market will question his intentions and damage Fed credibility.

What do Bond Traders Know?

There is an old market adage that argues bond markets are usually the first to pick up on changes in the economy. As a point of context consider that in June of 2007, ten year U.S. Treasury yields peaked at 5.25%. By the time the S&P 500 peaked five months later, ten-year yields had fallen nearly 1%. By the time the S&P was down 20% from most recent highs, ten-year yields had fallen to 3.50%. Clearly, in that time, the bond market was onto something well before the stock market.

On Wednesday, after the Fed’s statement and press conference, ten -year yields stood at 2.677% down from 2.740% before the announcement. In mid-November, 10-year yields were 3.206%. In the 10-weeks leading up to the formal reversal of Fed policy from tightening to pause, rates fell 53 basis points (0.53%). The Fed’s dovish tone is inflationary on the margin. Accordingly, bond markets should be concerned and yields should be higher especially the longer-dated bonds like 10s and 30s. They are not. What do bond traders know that the rest of us don’t?

Summary

The Fed has a long history of using economic jargon and, quite frankly, non-truths to help promote their agenda. The point of this piece is to assume that Powell is cut from the same cloth as his predecessors so we can understand what might be transpiring before it is generally known by the investing public. This knowledge puts us in a much better position to manage our investment and risk postures.

Clues from the Fed II, an RIA Pro article from November 28, 2018, provided important insight into one of Jerome Powell’s most important speeches as the Federal Reserve Chairman. We share the article to provide context to this article as well as to demonstrate the benefits of subscribing to RIA Pro.

Since the latter stages of Chairwoman Janet Yellen’s term and including the beginning of Powell’s term, the Fed has been on monetary policy autopilot. As a result of policy actions taken following the financial crisis, the fed funds rate was so far below the rate of inflation and economic growth that they felt comfortable raising rates on a steady basis without much regard for economic, inflationary and financial market dynamics. In Fed parlance, they were not “data dependent.”

Based on Powell’s most recent speech and policy trial balloons floated in the media, the fed funds rate is now much closer to the expected rate of economic growth, therefore it is much closer to what is known as the neutral fed funds rate. As a result, future Fed rate moves are expected to be increasingly influenced by incoming economic data. If true, this change in monetary policy posture is one to which the market is far less accustomed.

Powell’s Abrupt Change

On October 3, 2018, Jerome Powell stated the following: “We may go past neutral. But we’re a long way from neutral at this point, probably”

On November 28, 2018, he said: “Funds rate is just below the broad range of estimates of the level that would be neutral for the economy.”

In less than two months, the Fed Chairman’s perspective about the proximity of the fed funds rate to neutral shifted from a “long way” to “just below.” Clearly, something in Mr. Powell’s assessment shifted radically. We have some thoughts about what it might be, but we decided to canvas the opinions of others first.

We created a Twitter poll to gauge our follower’s thoughts on Powell’s pivot, which came despite very little evidence that economic conditions have meaningfully changed in the interim.

The poll results from over 1,400 respondents are telling. Accordingly, we provide a brief discussion of the respective implications for monetary policy and the stock market.

“Trump persuaded Powell”

President Donald Trump, a self-described “low-interest rate guy”, has been openly displeased with Jerome Powell and the Federal Reserve for raising rates. To wit:

• CNBC 11/27/2018– Trump told the Post, “So far, I’m not even a little bit happy with my selection of Jay,” whom he appointed earlier this year. The president told the newspaper that he thinks the U.S. central bank is “way off-base with what they’re doing.” — “I’m doing deals and I’m not being accommodated by the Fed,” Trump told the Post. “They’re making a mistake because I have a gut and my gut tells me more sometimes than anybody else’s brain can ever tell me.”
• WSJ 10/23/2018– “Every time we do something great, he raises the interest rates,” Mr. Trump said, adding that Mr. Powell “almost looks like he’s happy raising interest rates.” The president declined to elaborate, and a spokeswoman for the Fed declined to comment. — Asked an open-ended question about what he viewed as the biggest risks to the economy, Mr. Trump gave a single answer: the Fed.
• NBC 10/16/2018– “I’m not happy with what he’s doing because it’s going too fast,” Trump said of Powell. “You look at the last inflation numbers, they’re very low.”
• AP News 10/16/2018 – Stepping up his attacks on the Federal Reserve, President Donald Trump declared Tuesday that the Fed is “my biggest threat” because he thinks it’s raising interest rates too quickly.– Last week, in a series of comments, Trump called the Fed “out of control,”

The Fed is under increasing pressure from the White House to halt interest rate hikes. While we like to think Fed independence means something and the President’s pressure is therefore futile, there is a long history of Presidents taking explicit steps to influence the Fed and alter their actions.

29% of poll respondents believe that Trump’s comments made in the open, and those we are not privy to, are the cause for Powell’s change in tone. If this is the case, it likely means that Powell will shift towards a more dovish monetary policy going forward. This would entail fewer rate hikes and a reduced pace of Fed balance sheet normalization. Since the financial crisis, the precise combination of low interest rates and expanded balance sheet (QE) has proven extremely beneficial for stocks. Looking forward, excessive monetary policy amid a smoothly running economy is a recipe for inflation or other excesses which would not bode well for stocks.

We think this scenario is short-term bullish, but it could easily be diminished by higher interest rates or growing inflationary pressures.

Before moving on, it is important to note that Trump’s remarks above (and many other of his comments) are a first of their kind. This isn’t, because other Presidents haven’t said similar things but because Trump’s comments are in the public for all to see.

Economy Slowing Quickly

Votes that a quickly slowing economy produced Powell’s shift represented 42% of all responses. If correct, this is the worst case scenario for the stock market. Global economic growth is already decelerating as witnessed by the declining GDP growth posted by Germany, Canada, Italy, Japan and Switzerland in the most recent quarter. Further, China, the main engine for global economic growth since the financial crisis, is sputtering.

In addition to the global forces affecting the economy, the growth benefits seen over the last year from a massive surge in fiscal spending and corporate tax cuts are waning. Lastly, higher interest rates are indeed taking their toll on our debt-burdened economy.

It goes without saying that stocks tend to do very poorly during recessions, regardless of whether the Fed is dovish and lowering rates. During the past two recessions, the S&P 500 dropped over 50% despite aggressive interest rate cuts.

We think this scenario is decidedly bearish.

Stock market woke him up

The “Greenspan Put” is a phrase that was used to describe Fed Chairman Alan Greenspan’s preemptive policy moves to save the stock market when it was headed lower. While Greenspan’s name is on the term, it goes back even further. Following the crash of 1929, for instance, the Fed made enormous efforts to halt stock market declines to no avail. In recent years, the Greenspan Put has taken on more significance as Ben Bernanke and Janet Yellen followed in his footsteps and spoken repeatedly about a beneficial wealth effect caused by higher share prices.

In the past, Powell has expressed reservations about the policy measures taken by his predecessors and has openly worried about the risk of high stock valuations and other potential imbalances. He has generally demonstrated less concern for protecting the stock market. With the market falling and the proverbial rubber hitting the road, we are about to find out if a 10% decline from record highs is enough to scare Powell into a dovish stance. If so the Greenspan, Bernanke, Yellen, Powell put is alive and well.

As previously mentioned, there have been several occasions in years past when the market suffered steep declines despite the presence of the Fed Put.

We think this scenario is bullish on the margin, but it may not be enough to save the market.

Summary

As judged by the voting, the most likely explanation accounting for Powell’s sudden and aggressive change in tone involves some combination of all three factors. Like most central bankers, he probably believes that he can engineer a “soft landing.” In other words, he can allow the current global and domestic economic pressures to reduce economic growth without causing a recession.

While such a plan sounds ideal, the ability to execute a soft landing has eluded central bankers for decades. Some will say the Fed, by delaying plans for rate hikes and reducing their balance sheet, avoided a hard landing in 2015 and 2016. They may have, but since then global economic and political instabilities have risen markedly. This makes a repeat execution of a soft landing much more difficult. A second concern is that the Fed, with rates still historically very low, does not have enough fire power to engineer a soft landing.

We will continue to pay close attention to the Fed for their reaction to what increasingly looks like a changing economic environment. We also leave you with a reminder that, while the Fed is powerful in igniting or extinguishing economic activity, they are simply one of many factors and quite often throughout their 105-year history they have fallen well short of their goals.

The market is a highly complex global system influenced more by the unseen than by the obvious. Jay Powell, like most of his predecessors who thought they could control market outcomes, apparently suffers from this same critical handicap. Of all the moral hazards the Fed sponsors, their hubris is certainly the most destructive. The stability of the last ten years and the shared perception of Fed control will lead many to forget the sheer panic that occurred only a decade ago.

The following speech by Jerome Powell, Chairman of the Federal Reserve, was given on November 28, 2018. Highlighted below are quotes which we believe are important in helping to determine current Fed posture and inclination. Intertwined within his speech you will find our comments and explanations. Please also see our summary thoughts following the speech below. If you have not read our review of Vice-Chairman Richard Clarida’s speech from yesterday you can find it HERE.

---

The Federal Reserve’s Framework for Monitoring Financial Stability

Chairman Jerome H. Powell

At The Economic Club of New York, New York

It is a pleasure to be back at the Economic Club of New York. I will begin by briefly reviewing the outlook for the economy, and then turn to a discussion of financial stability. My main subject today will be the profound transformation since the Global Financial Crisis in the Federal Reserve’s approach to monitoring and addressing financial stability. Today marks the publication of the Board of Governors’ first Financial Stability Report. Earlier this month, we published our first Supervision and Regulation Report. Together, these reports contain a wealth of information on our approach to financial stability and to financial regulation more broadly. By clearly and transparently explaining our policies, we aim to strengthen the foundation of democratic legitimacy that enables the Fed to serve the needs of the American public.

Outlook and Monetary Policy
Congress assigned the Federal Reserve the job of promoting maximum employment and price stability. I am pleased to say that our economy is now close to both of those objectives. The unemployment rate is 3.7 percent, a 49-year low, and many other measures of labor market strength are at or near historic bests. Inflation is near our 2 percent target. The economy is growing at an annual rate of about 3 percent, well above most estimates of its longer-run trend.

For seven years during the crisis and its painful aftermath, the Federal Open Market Committee (FOMC) kept our policy interest rate unprecedentedly low–in fact, near zero–to support the economy as it struggled to recover. The health of the economy gradually but steadily improved, and about three years ago the FOMC judged that the interests of households and businesses, of savers and borrowers, were no longer best served by such extraordinarily low rates. We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth. My FOMC colleagues and I, as well as many private-sector economists, are forecasting continued solid growth, low unemployment, and inflation near 2 percent.

---

RIA Pro comment– In these first two paragraphs Jerome Powell points out that the economy is running above its longer-term trend in large part due to the support of “near zero” interest rates (Fed monetary policy). Given recent above-trend economic growth and a sustained recovery from the financial crisis, the Fed raised rates to get to a less simulative level.

He states that “interest rates are still low by historical standards” and “remain just below” what they would consider neutral for the economy. The phrasing “remain just below” is the key line from the speech as it was only a month ago, on October 3^rd, when he said they were a “long way” from neutral. In no uncertain terms, this abrupt change in posture is a clear signal to the market that the Fed may be close to ending their hiking cycle.

There are two other important points regarding the neutral rate worth discussing. First, the Federal Reserve does not know with any real precision what the “neutral” rate of interest for the economy is or should be. This is best left to un-manipulated markets and the independent buyers and sellers that drive them. Second, if indeed Powell and the Fed did know with certainty where the neutral rate should be, it likely would not be at a real rate near zero, with economic growth running above 3% and the unemployment rate at 50 year lows as is currently the case.

---

There is a great deal to like about this outlook. But we know that things often turn out to be quite different from even the most careful forecasts. For this reason, sound policymaking is as much about managing risks as it is about responding to the baseline forecast. Our gradual pace of raising interest rates has been an exercise in balancing risks. We know that moving too fast would risk shortening the expansion. We also know that moving too slowly–keeping interest rates too low for too long–could risk other distortions in the form of higher inflation or destabilizing financial imbalances. Our path of gradual increases has been designed to balance these two risks, both of which we must take seriously.

We also know that the economic effects of our gradual rate increases are uncertain, and may take a year or more to be fully realized. While FOMC participants’ projections are based on our best assessments of the outlook, there is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us. As always, our decisions on monetary policy will be designed to keep the economy on track in light of the changing outlook for jobs and inflation.

---

RIA Pro comment- Powell is parroting the substance of Clarida’s speech yesterday essentially saying that the Fed is no longer on rate-hiking auto-pilot. They will raise rates or abstain from raising rates based on what economic and financial data tell them (data dependency). As we mentioned yesterday, the increased emphasis on data dependency by definition reduces their reliance on forward guidance which will introduce more volatility to the markets. Prior reliance on forward guidance helped suppress volatility, so it follows that less reliance on it will make them less predictable and naturally raises the level of uncertainty for investors.

---

Under the dual mandate, jobs and inflation are the Fed’s meat and potatoes. In the rest of my comments, I will focus on financial stability–a topic that has always been on the menu, but that, since the crisis, has become a more integral part of the meal.

We omitted the rest of the speech as its focus is a historical perspective of financial stability and less relevant to current monetary policy. The entire speech can be found HERE

RIA Pro Summary

It is clear from this speech, as well as recent trial balloons put out by the Fed, that they are taking a more dovish stance. This does not mean they will halt their rate hikes, but in our opinion it is clear that once we move beyond the scheduled hike in December, all bets are off the table. Barring signs of wage growth, stronger inflation or sustained economic growth above 3%, they are unlikely to raise rates further.

The stock market rocketed higher on what is perceived as a dovish speech with the strong possibility that Fed hikes will be halted come 2019. Time will tell if the gains are sustainable and if the market is interpreting his speech correctly. It is worth mentioning however that a recession followed the last three times that the Fed Funds rate hit a cycle high.