Mad Hatter: “Why is a raven like a writing-desk?”
“Have you guessed the riddle yet?” the Hatter said, turning to Alice again.
“No, I give it up,” Alice replied: “What’s the answer?”
“I haven’t the slightest idea,” said the Hatter.
- Alice in Wonderland
A lot of investors are feeling like Alice in Wonderland, trying to figure out the riddle that is the Federal Reserve’s thought process. Investors are trying to understand why the Federal Reserve is so reticent to raise its target for the federal funds from its current 0 to ¼%. Its press release is fairly concise and offers quite a bit of insight into their thinking – I highly recommend actually reading it, not just a newspaper summary of it. As someone who thinks that rates should be higher, and banking regulation lower, because that is what will drive our economy upward, I’m trying to see what the Fed sees.
What matters in investing is not what you think things should be but instead understanding what things are. And what things “are” today is lower rates for longer. So why are things the way they are? What does the Fed see that the rest of us don’t?
Taking the press release as a guide, the Fed is focused on the following areas of the economy:
Business Fixed Investment
From the release, they state that all of these areas are “improving” or “increasing moderately”, with the exception of exports, which have been “soft.” While they are worried about “global economic and financial developments” restraining economic activity, they believe that “with appropriate policy accommodation” (ie, lower-than-normal Fed Funds rates) that “economic activity will expand at a moderate pace.”
“Take some more tea,” the March Hare said to Alice, very earnestly.
“I've had nothing yet,” Alice replied in an offended tone, “so I can't take more.”
“You mean you can't take LESS,” said the Hatter: “it's very easy to take MORE than nothing.”
- Alice in Wonderland
Implied in the release is that each of these areas, absent the magical interventions of the Fed, would not be expanding at a moderate pace. It also implies that these areas of the economy are helped by low rates – in fact, that these areas need rates at zero to improve even moderately. That is not a very bullish outlook for the state of the economy years after Lehman imploded. Seven years later and we still are barely expanding, and the Fed thinks that MORE of the same, more of nothing, is the answer. But if, seven years on, more of nothing isn’t really working, according to your own analysis of the situation, then maybe the right thing to do is to try something different. That would be the logical approach in my mind. Zero rates did not jump start Japan – in fact, they have had zero rates for 20 years without inflation, and their economy has been stuck in a rut the whole time. Here in the U.S. we have had zero rates for seven years and inflation is going down, not up, and the Fed thinks our expansion basically stinks.
At what point will the Fed realize that setting interest rates really low doesn’t help the real economy much? It did help avoid an apocalypse in financial markets in 2009/2010, but those risks are behind us (at least here in the U.S.). But now, what is holding back our economy is not the level of rates but the level of regulation and bureaucracy in our economy. If you are GE or Coca-Cola, you have refinanced your debt and lengthened your maturities a number of times in the past seven years. Slightly higher (say 200 basis points) rates aren’t going to hurt you. If you are a home buyer, unless you have pristine credit, lower rates haven’t really helped you because you can’t get a mortgage without herculean efforts – the paperwork, the regulations put in place by the Consumer Finance Protection Bureau (CFPB), make lending very onerous for community banks and borrowers. All the fines and penalties the Justice Department has been imposing on the banking industry have made bankers question whether mortgage lending is worth the risks. It was already a marginal business pre-2008. Now, its fraught with risk – if you lend someone money and they do pay you back, you make say 3.5% to 4%. If they don’t, you have a hard time collecting because of all the processes and legal maneuvering that needs to take place. It’s basically a lose-lose proposition for the banks today. If the Fed really wants to move the economy into a higher gear, it should remove the barriers to lending it has put in place in the past seven years, it should work with the regional and community banks it regulates as partners, not as adversaries, and it should make it profitable for these banks to make loans again by raising the level of interest rates so that they can make some money from their lending.
“But I don’t want to go among mad people," Alice remarked.
"Oh, you can’t help that," said the Cat: "we’re all mad here. I’m mad. You’re mad."
"How do you know I’m mad?" said Alice.
"You must be," said the Cat, "or you wouldn’t have come here.”
- Alice in Wonderland
I wonder what it must be like to live in your own dreamworld, divorced from reality, where you actually believe that what you do matters so much to the world’s economy that you must be extremely careful with what you say and do, otherwise people will stop working, companies will stop producing, whole economies will come screeching to a halt with rioting in the streets and starvation everywhere. It must be so strange to believe that raising the Fed Funds target rate a mere 25 basis points will cause all this havoc, so strange to believe that you have this magical power over people’s decision making as to whether or not to start a company, expand one, sell one, or close one. Personally, I don’t know how they sleep at night, thinking that by making this momentous decision that they will unleash these catastrophic forces that they will be unable to stop. But what if.. instead of unleashing hell, a strange thing happened. Nothing. The economy didn’t stop, kids still went to school, people still went to work, and life went on. What if the only thing that happened is that a few emerging markets currencies depreciated, and a few macro funds took some losses, and maybe in a worst case, our stock market went down a bit. Would that end the world as we know it? Would we be in a recession again? I seriously doubt it. It used to be that market declines of 10-20% happened fairly regularly, a normal ebb and flow as markets adjusted to earnings and changes in the real economy. Stocks are not being so finely modeled that 25 basis points changes the NPV calculation (or at least they shouldn’t be if you have any common sense).
“It’s no use going back to yesterday, because I was a different person then.”
– Alice, Alice in Wonderland
I’m not saying that interest rates play no role in the real economy. What I am saying is that the Fed has gotten so caught in its own world that it thinks that every little move it makes matters. Volcker used a sledgehammer to stop inflation. Greenspan used a fire house to jumpstart our economy in 2002. Big moves in rates do matter, and do impact things like lending and banking and investment decisions. But small ones don’t. The Fed has gotten caught in a weird dream world where it thinks that it is like Jacques Seurat, where every fine detail in their painting matters, when instead they should be thinking like Jackson Pollock, where the broad, dramatic movements are what creates the masterpiece. We’re very far from yesterday, where the Fed made big moves in rates to have a real impact on the economy. Today, we’re in a world where rates will be lower for longer than they should be, and that is the reality we have to live with and adjust to. What we think rates “should be” is irrelevant – you can’t invest on “should be”, you have to invest on what will be. And after Thursday’s statement, it’s clear that this Fed is definitely led by a different person than in the past.
This week’s Trading Rules:
Support: 194.5, 192, 188/189, then not much.
Resistance: a lot at 197/199, then 201 and 205.
Positions: Long and short U.S. stocks and options, Long SPY Puts.
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Miller’s Market Musings is a free weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here.
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