Wednesday, November 18, 2015

Fed liftoff is good news

Today the release of the October FOMC minutes increased the likelihood (now about 70% according to implied pricing) of a modest rise in short-term interest rates next month. The market has been dreading such a move for years, but now that it is finally upon us, investors are shedding their fears, albeit slowly. After all, if the Fed is confident enough to end ZIRP, shouldn't we all be a bit more confident in the future? The economy is certainly not sizzling, but neither is it sputtering. It's been growing at a 2 - 2.5% pace for some six years now—the weakest recovery ever, to be sure, but a fairly steady one. Moreover, the economy has already withstood several shocks over the years—the PIIGS crisis, a Greek default, the fiscal cliff negotiations, the collapse of oil and commodity prices, and the devaluation of the Chinese yuan and the plunge in Chinese stocks—without skipping a beat. Perhaps most importantly, the prices of gold, stocks, and TIPS have been pointing to better times ahead for some time now.

The chart above shows the ratio of the S&P 500 index to gold prices, and it is divided into periods in which the ratio was rising (white) and falling (green). The numbers in red show the annualized rate of GDP growth during each period. Growth has been slower during times when gold is outperforming stocks, and faster when gold is underperforming. The ratio has been trending up for several years now, suggesting that growth could pick up further in the years to come. Investors tend to prefer gold during times of great uncertainty, and they tend to shun gold during times of rising confidence. Think of the green periods as times when investors run away from financial assets and embrace hard assets, and the white periods as times when financial assets look more attractive than hard assets. Good times for financial assets mean investment is generally strong, and investment is ultimately what drives growth.

Gold prices started falling in early 2011, and a year or so later TIPS prices started falling as well (the chart above uses the inverse of the real yield on TIPS as a proxy for their price). I've referred to this chart repeatedly in recent years, citing it as a good sign that pessimism is being slowly replaced by optimism.

Falling TIPS prices are the flip side rising real yields, of course, and real yields tend to track the economy's underlying real growth rate. So falling gold and TIPS prices are good signs that the market is becoming more confident about economic growth, and all this has happened as stocks have outperformed gold.

Real yields on 5-yr TIPS can be thought of as the market's expectation for the average real Fed funds rate over the next 5 years. Rising real yields over the past two years are a sign that the market has gradually become more confident that the Fed would sooner or later start raising real short-term interest rates. In the years to come, we are likely to see both TIPS real yields and real short-term rates continue to rise, and they should be accompanied by an improving economic growth outlook.

The chart above compares stock prices (blue) with the ratio of the Vix index to 10-yr Treasury yields (red), the latter being a proxy for the market's fears, doubts, and uncertainties. Every selloff in stock prices has been accompanied by a sharp rise in the market's fears, while rallies have tended to occur as fears have subsided.

Not surprisingly, as the chart above shows, consumer confidence has been rising since 2011, along with the fall in gold and TIPS prices, and the rise in stock prices.

All of the above point to better times ahead, driven fundamentally by improving confidence.


Benjamin Cole said...

Well, the Fed has consistently overestimated pending inflation for years, as well as economic growth, so I have limited confidence in their ability to forecast. Or anybody's for that matter. Like Yogi Berra said...
Why not sowly normaliize interest on excess reserves? Reduce by one basis point a month the interest that the Fed pays on excess bank reserves.

Japan has lower rate of inflation than the United States, and a lower unemployment rate.

The Bank of Japan pays 0.10% on reserves.

The Fed may be tightening, but every central bank that has tightened since 2008 has had to reverse course.

Thinking Hard said...

We have already been tightening relative to most of the world. QE3 ended in October 2014. Check out what the shadow rate has done since then:

Oct 2014: -2.8%
Oct 2015: -0.53%
Diff: 227bp over 12 months
Note: lowest shadow rate was May 2014 at -2.99%
Diff from bottom (May 2014) to Oct 2015: 246bp over 18 months

The average fed rate hike cycle lasts 414 days or almost 14 months. The Fed increases interest rates by an average of 281bp over the rate hike cycle. Since 1983, the minimum duration of the rate hike cycle has been 262 days and maximum 729 days. The minimum interest rate increase has been 1.375% and the maximum 4.25%.

WSJ Dollar Index:
May 2014: 72
Oct 2014: 78
Now: 90

There is a strong case to be made that the rate hike cycle (or really monetary tightening cycle) has already begun and interest rates do not have a high probability of exceeding 1-2% FFR during this rate hike cycle. Looking at the shadow rate bottom of -2.99 to a 1% FFR would mean a 399bp increase, nearing the maximum interest rate increase during any cycle since 1983.

Fed dot plot from September 2015 has the Fed projecting the FFR to range from 1-2% in 2016, 2-4% in 2017, and 3-4% in 2018 and beyond. When looking at various shadow rate models, this would blow way past both the maximum duration and maximum rate increase in any interest rate cycle since 1983.

Lower, slower, for a lot longer than many people think. We are further along than most economists and market experts think. The Fed President in Minneapolis, Narayana Kocherlakota, is the sole dissenter in the dot plot projecting the need for negative rates next year and 1% in 2017. I’m not sold on negative rates at this time, but see a much higher probability of continued easing measures before we see 2% FFR.

ECB looking at more easing by Q1 2016. Japan in another recession and likely to ease further. PBOC looking at easing measures. The world is tightening for the U.S. Why exacerbate the issue by raising the FFR in a low and stable inflationary environment?

vito said...

Its been a while, thanks for posting and have a good Holiday Season.

Benjamin Cole said...

Thinking Hard---the Fed is trapped by its own recent promises to raise rates and by the incorrect perspective that interest rates alone reflect what is monetary policy.

As you correctly point out, the nominal interest rate can often be misleading. The Fed has, in effect, been tightening for years.

It is incorrect to describe the Fed as "accommodative" since 2008. The proof is we now see inflation at historic lows.

The Fed appears inclined to raise interest rates. Of course, long term rates will only go down in reaction to a Fed rate hike, and the economy will slow.

As Miltin Friedman said, you cannot tighten your way to higher interest rates, at least not for long.

Matthew Grech said...

Thanks Thinking Hard. That was a fascinating chart... The move of the last year and a half seems to be supported by so many other market-based prices.