Two Ways Forward for the Fed

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On Wednesday, March 18, the Federal Open Market Committee of the Federal Reserve formally ended its long-standing practice of forward guidance.

This is highly significant for understanding the future path of Fed policy and its impact on markets. A brief review of forward guidance will explain why…

Since the creation of the Federal Reserve in 1913, interest rates have been the primary tool used by the Fed to ease or tighten monetary policy and affect the economy. However, in 2008, the interest rate directly controlled by the Fed, called the “federal funds fate,” reached zero. At that point, the Fed had to resort to other tools to ease monetary conditions.

The best known of these tools was money printing, called “quantitative easing,” or QE. Another tool involved selling short-maturity Treasury notes and buying longer maturities to affect the shape of the yield curve. This was known as Operation Twist.

Forward guidance is the other tool in the toolkit. It consists of using particular words and phrases to indicate the future path of Fed policy.

Since the words used are somewhat arbitrary, Fed officials supplement forward guidance with secret phone calls to selected journalists including Jon Hilsenrath of The Wall Street Journal. These journalists then provide the needed interpretation to their readers.

The impact of forward guidance has to do with how markets price longer-term Treasury securities. For example, a 10-year Treasury note is priced as if it were a strip of shorter-term securities.

A dealer prices a 10-year note using the present value of, say, a 1-year note today, then a 1-year note a year from now, then a 1-year note two years from now and so on. Various methodologies can be used, but the basic idea is that a long-term note is priced using today’s expectations about the future path of short-term rates.

The market makers in the Treasury markets are too-big-to-fail banks and a few smaller firms called “primary dealers.”

The primary dealers must stand ready to buy or sell Treasury securities at the request of their customers. To do this, they carry inventories of Treasury notes. These inventories are financed on a short-term basis, sometimes overnight, using repurchase agreements — the so-called “repo market.”

The repo market rate is close to the fed funds rate; both are near zero. Ten-year Treasury notes have traded with a yield-to-maturity of about 2–3% for the past several years. A dealer who buys 10-year notes and finances them in the repo market can make spreads of over 2% with almost no credit risk. If this trade is leveraged 10:1, the return on dealer equity can be 20% or more.

It sounds almost too good to be true, but there’s a catch. The dealer is financing a 10-year asset with overnight funds. If the repo rate rose sharply, the dealer could find that its profitable spread disappears. In a worst case, the spread could go negative and the dealer might have to dump the 10-year note at a loss.

Facilitating this profitable spread trade was the hidden purpose behind forward guidance. The Fed took the risk out of the trade by guaranteeing that overnight rates would not go up. In effect, the Fed was saying to dealers, “Go ahead, use leverage and take maturity risk. We’ve got your back.”

This was a way to allow banks to make excess profits to restore the capital they lost in the 2008 crash. As long as the Fed offered protective forward guidance, the dealers could safely do this spread trade knowing that repo rates would not go up. Keeping rates low hurt the everyday saver, but the Fed did not care. The Fed’s job was to help the big bank dealers, not everyday Americans.

The history of forward guidance is as tortured as the rationale. In March 2009, the Fed issued an announcement that short-term rates would remain at zero for “an extended period.” In August 2011, the “extended period” phrase was dropped and a specific date of “mid-2013” was announced as the earliest date rates would increase.

By January 2012, this date had been pushed back to “late 2014.” Finally, in September 2012, the Fed announced that the earliest that rates would increase was “mid-2015.”

In December 2012, with unemployment at 7.8%, the Fed scrapped its practice of using target dates for forward guidance and substituted a strict numeric goal of 6.5% unemployment as a threshold for possible rate increases.

In 2014, as unemployment crashed through the 6.5% barrier on its way to 5.5%, the Fed quietly abandoned the numeric goal also and resorted to words and phrases promising not to raise rates for “a considerable time.” Finally, an exasperated Fed simply said it would be “patient” before raising rates.

Now that patience too has been abandoned.

As can be seen from this history, the entire process of forward guidance has been an elaborate farce in which markets and investors have played their assigned roles. Federal Reserve officials have told me privately that they have no idea what they are doing — something they never say publicly.

They simply try some policy as a kind of experiment. It if appears to work, they may do more of it. If it appears to fail, they promptly abandon it. The biggest mistake investors can make is to believe the Fed knows what they are doing — they don’t.

One alternative to forward guidance is to use the Taylor rule, named after its creator, Stanford economist John B. Taylor. The Taylor rule and its variations were used successfully by the Fed in the 1990s to produce strong growth and low inflation.

The rule itself is straightforward, specifying a policy rate based on comparisons of actual inflation, target inflation, actual GDP and potential GDP. However, Janet Yellen, chair of the Fed, has flatly rejected the use of the Taylor rule for setting policy, so its consideration today is purely academic.

Where are we now? The Fed ended forward guidance in March 2015. QE was ended in November 2014. The Taylor rule was abandoned even earlier. Today there is no guidance, and there is no rule.

All that remains is Fed discretion based on their forecasts and incoming data. Investors have no other way of understanding what the Fed will do next, even though the potential value of every security in an investor’s portfolio depends on it to some extent.

The problem with Fed forecasts is that no major institution has a worse forecasting record. This is illustrated in the chart on the next page.

The black line with dashes shows actual GDP growth 2009-2014. The colored lines represent Fed forecasts given at various times over the past five years as indicated. They are situated along the part of the timeline to which the forecast relates:

Every Fed forecast overstated actual growth by a wide margin. For example, the forecast given in November 2011 projected growth would be over 3.5% by mid-2014.

Actual growth was about 2.5%. Given this dismal track record, we should expect that future Fed forecasts will be wrong also and that actual growth will be weaker than expectations.

These forecasting errors are not just a coincidence or a run of bad luck. The forecasts are based on equilibrium models and past data, neither of which applies to the real world.

As we’ve written before, the economy is not an equilibrium system, and current circumstances do not resemble a typical cyclical recovery. The economy today is in a depression, with dynamics not seen in over 80 years.

The other guide to Fed action is economic data, what the Fed calls “data dependent” policy. The problem with data is that it comes in real-time or is slightly backward looking. The Fed also likes to see several months of data before making a change in policy.

Taken together, this means that the Fed might talk about rate increases for months to come before they realize the economy is too weak to justify them. Worse yet, the Fed might actually increase rates based on flawed forecasts and declining unemployment at exactly the point when the economy is tipping into recession and deflation. The result would be a market meltdown here and abroad.

The Fed is flying blind with flawed forecasting tools and backward-looking data. Meanwhile, the economy is showing weakness consistent with the late stages of an expansion and the early stages of a new recession. This leads to two possible outcomes.

Scenario A is that the Fed sees the weak economic signals before they raise rates. In that case, they will not raise rates in 2015 and may even go back to QE in early 2016. Stock markets might maintain momentum and even reach slightly higher levels as continued ease offsets the drag from deflation and weak growth.

Scenario B is that the Fed overestimates growth based on their flawed models and relies on the employment data while ignoring other danger signs. In that case, they might raise interest rates in September or December of this year.

Stock markets around the world could crash as liquidity dries up. Emerging markets would suffer the most because of a stronger U.S. dollar combined with a global dollar shortage. But U.S. markets would not be immune from this misguided and premature tightening.

I find Scenario A the most likely path, but Scenario B cannot be ruled out. The key for investors is to identify asset classes that can perform well in both states. The best protection comes from 10-year Treasury notes. These will perform well in Scenario A, because deflation is still a powerful force even if the Fed keeps policy on hold.

They will do even better in Scenario B. The immediate reaction to a Fed rate increase may be slightly negative for notes, but once it becomes apparent that the Fed has tightened at exactly the wrong time, notes will rally on the resulting economic slowdown.

Another good asset is a small sleeve of physical gold as insurance against market disruption caused by Fed blunders. Finally, cash will serve investors well both as a deflation hedge and to reduce volatility in other parts of a portfolio.

Nothing of significance will happen at the Fed meeting ending tomorrow. This is because the Fed earlier promised not to raise rates before the second meeting following removal of the world “patience.” Since patience was removed in March, April is too soon for a rate liftoff. There is no Fed meeting scheduled for May.

The next Fed meeting of any significance is June 17.

It is unlikely the Fed will raise rates then, but it cannot be ruled out. In any case, investors have at least 60 days to breathe easy without immediate fear of Fed intervention.

Regards,

Jim Rickards
for The Daily Reckoning

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