yesterday’s Fed meeting announcement

My experience with Fed meetings is that the stock market usually heads off in the wrong direction on the release of the Fed statement and accompanying documents, but then quickly reverses course and moves in the way one might reasonably have predicted by actually reading the Fed materials.  This is not just computers trading.  The US market has operated this way for as long as I can remember.

Not this time, though.  Instead, the S&P made an immediate strong upward move   …and never looked back.

What’s different this time?

I think it’s the PDF where the Fed shows, among other things, where its voting members believe the Fed Funds rate will be at the end of this year, next year and in the longer term.

The previous release, in December 2014, showed the median estimate for 2015 at 1.0%.  For 2016, the figure was 2.5%.

Yesterday’s, in contrast, suggests the rate will be between 0.5% and 0.75% this December, and at 1.75% as we enter 2017.

That’s a big haircut for just three months.

The factors involved in the change are:

–the rise in the US$,

–moderation in domestic economic growth over the first quarter, and

–the lack of any sign of inflation.

Stocks and bonds spiked on the news.  The US$ came off its highs.

my take

Investors continue to be fixated on the numbers the Fed releases, and to be distrustful of any qualitative statement by the Fed saying it has taken the tragic 1990s example of Japan seriously and will err on the side of caution in raising rates.  Doesn’t make a whole lot of sense to me that the market doesn’t believe this, but it’s the way it is.

My stocks were having an unusually strong day yesterday before the Fed announcement.  They lost a bit of their relative strength afterward, though.  Arguably, this shows I was preparing for faster rate increases than the market now thinks will occur. I have no desire to become more aggressive, but I will be interested in how my stocks fare today.

I’ve been mulling over whether to try to play a potential rally in domestic-oriented EU stocks.  My experience is that this isn’t safe until the domestic currency in question has stopped falling.  I wonder if yesterday was a turning point?  Again, more data today.

the December 2014 FOMC

The US stock market has rallied strongly since the Fed released a statement from its Federal Open Market Committee meeting on Tuesday-Wednesday and Chairperson Janet Yellen had her accompanying press conference.

The broad picture:

In October, the Fed ended a long period of continually upping the level of monetary stimulation of the US economy.  It is still in a period of applying extreme stimulation but is no longer increasing the amount.  And it is now starting to focus on the nuts and bolts of how to begin to wean the economy from excessive monetary stimulus, a process the Fed envisions will take several years.

Janet Yellen’s main points:

–there’s no set timetable for withdrawing excess stimulus.  The process consists in gradually raising the Fed Funds rate for overnight money from the current zero to a normal level of 3%+.  Most FOMC members think the first rate rise should come during 2015, but the Fed is prepared to slow down the process if the economy is weaker than expected, and vice versa.

Wall Street fears that the Fed will willy-nilly raise rates according to a predetermined formula and without regard to economic conditions is completely misplaced.  The Fed will be patient in this process (the Fed estimate of where Fed Funds will be at the end of 2015 continues to come down and is now at 1.15%; speculation is that the figure Ms. Yellen has in mind is lower).  The major goal is not to disrupt growth.

–inflation is not a current problem.  The Fed has been trying hard with every tool in its arsenal to create conditions where inflation is a possibility for six years without much success.  The Fed did say that it expects inflation will only gradually rise toward its 2% target.  Wall Street fears of runaway inflation are unrealistic.

–deflation isn’t a concern, either.   Investors worried about deflation are making the rookie mistake of confusing headline inflation figures, which contain lots of transitory elements, with core inflation–which is what really counts and which is steady at somewhat under 2%.

–lower oil prices are a net plus for the US, because the country is still a large oil importer.  A Russian recession is more a trouble for the EU than the US.  US trade with Russia is very small; US holdings of Russian portfolio and capital assets are tiny.

Other than its comments about oil, almost nothing the Fed said breaks new ground.  Given the tragic example of Japan’s mistaken attempts to remove economic stimulus too soon, it’s not surprising that the Fed said it will not repeat them here.  The main takeaway from the meeting statement/press conference is that the Fed said this explicitly and in detail, leaving little for the Wall Street rumor mill to worry about.

two more years of emergency-low interest rates!

the January 25th Fed meeting

Last week’s meeting of the Federal Reserve’s Open Market Committee had two important results:

1.  Chairman Ben Bernanke said the Fed funds rate, which has been at effectively 0% for just over three years (since December 16, 2008–how time flies) will likely remain at or near the current low rate into 2014.

2.  The Fed gave more detail than ever before on its thinking about prospects for the US economy and the appropriate level for the Fed funds rate.

The Fed thinks:

–the long-term growth rate of the US economy is  +2.4%-2.5%  a year (vs. 3%+ a decade ago).  The agency is content, however, to allow growth at somewhat above that rate from now into 2014.

–the appropriate long-term level for the Fed funds rate is about 4.5%, which amounts to a 2.5% real rate of interest (“real” means after subtracting inflation from the nominal rate).  This contrasts with the current rate, which is a negative real rate of about 2.5%.

–although the process of normalizing interest rates will probably begin before the end of 2014, the Fed is unlikely to raise the funds rate above 1% until at least 2015.

–despite the immense monetary stimulation going on now, inflation will not be an issue.  It will remain at 2% or below.

–the “natural” rate of unemployment, that is, full employment, is 5.5% of the workforce (in theory, the 5.5% is friction in the system–like people in transit from one employment location to another, or who decide to take a short break between jobs…).

According to the Fed’s projections, the unemployment rate will remain above 8% until some time in 2013.  It probably won’t crack below 7% for at least the next three years.

implications

The forecast itself isn’t a shocker.  The Fed has been talking about slow but steady progress for the economy, with no inflation threat, for some time.  The real news is that the Fed expects the current situation to persist into 2105, a year longer than it had previously indicated.

1.  To my mind, the biggest implication of the Fed announcements is that it makes less sense than ever to be holding a lot of cash.  How much “a lot” is depends on your economic circumstances and risk preferences.  But the Fed is saying that a money market fund or bank deposit is going to yield nothing for the next two years and well under 1% for the year after that.  Yes, you have secure storage in a bank and substantial assurance you won’t make a loss, but that’s about it.

To find income in liquid assets–as opposed to illiquid ones like, say, rental real estate–you have to look to riskier investments, dividend-paying stocks or long-dated bonds.  That in itself is nothing new.  Savers have been reallocating in this direction for the past couple of years.  Last week’s Fed’s message, though, is that it’s much too early to reverse these positions.  If anything–and, again, depending on personal circumstances and preferences–investors should think about allocating more away from cash.

2.  When the process of normalizing interest rates is eventually underway, the yields on long-dated bonds and dividend paying stocks will be benchmarked–and judged–against cash yields of 4%+.  For stocks, a static dividend yield of 3% won’t look that attractive.  At some point, low payout ratios (meaning the percentage of earnings paid out in dividends) and the ability to increase cash generation will become key attributes.  Both are indicators of a company’s ability to raise dividends.

3.  It’s my experience that when the Fed begins to tighten, Wall Street always underestimates how much rates will rise.  Last week, the Fed told us that when the Fed funds rate goes up this time, its ultimate destination is 4.5%.

4.  Investors taking a top-down view, that is, looking for the strongest economies, will have to seek exposure outside the US–which will only look good vs. the EU and Japan.  The main issue is demographics–an aging population.  It’s probably worthwhile to try to figure out what characteristics of the latter two economies, both of which have older populations than the US, are due to social/cultural peculiarities and which are due to aging.  The second set of traits may well turn up in the US market as well.

5.  The mechanics of how growth stocks and value stocks work may change in a slower-growing economy.  It’s hard to know today how that will play out.  True growth stocks may be harder to come by.  Value investors who say they buy asset value of $1.00 at $.30 and sell it at $.70 may have to buy at $.20 and sell at $.60 if there’s less room for second- and third-tier companies to succeed.

I think it’s way too soon to be worrying about anything other than #1.  The rest are thoughts to be filed away for next year, maybe.