Given the recent rise in long term interest rates, the gush of money flowing out of bond funds, and high expectation for the Federal Reserve to start tapering its large scale asset purchase program, I was prompted to refresh my memory on the actual pricing of a change in the federal funds rate, the Fed’s primary tool for changing monetary policy. Let’s review what is going on with monetary policy and look at a few indicators which could signal a shift in the Federal Reserve’s interest rate policy.
The Fed is widely expected to announce a $10 to $15 bln tapering of its large scale asset purchase program on September 18th after its FOMC meeting. The Fed is likely to embark on a program of gradual withdraw of purchases into 2014. The idea of taper is well discussed and mostly likely priced by market participants.
The Fed’s statement on short rates:
In its September 18th statement, the Fed is likely to reiterate its desire to keep rates low for a long period. The statement from the last FOMC announcement highlighting the committee’s desire to keep rates low for a prolonged period was: ”In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent”.
What will traders watch?
Traders will be looking at two factors when assessing the impact of policy on the markets. 1) How quick will the Fed taper. The Fed currently buys $85 bln a month split $45 bln in long term treasures and $40 bln in mortgage securities. 2) The Fed’s statements relating to the federal funds rate.
Answering question 1:
It’s anybody’s guess, but my view rests in the Fed finishing up with its treasury buying by the end of the year and then starting to work on scaling back MBS purchases in 2014. The Treasury is cutting coupon sizes, there are concerns the Fed is hurting liquidity in the treasury market, and the housing market could use more time to strengthen give the recent rise in mortgage rates. The market may fret a little about the pace of withdrawal, but for the most part the trade is expecting the Fed to methodically end the program. The benefit of the program has been limited given a paper published by the San Francisco Fed.
The wild card is the announcement of a new Fed Chair. Recent press reports give the edge to Larry Summers over Janet Yellen, but worries over Summer's Senate confirmation have kept Yellen in the race. Summers is viewed as more hawkish and Yellen more dovish. Their influence or the view of another new Fed Chair could quicken or slow the pace of taper.
Answering question 2:
The more important question for the market rests in the timing of an actual increase in the Fed’s traditional policy tool, the fed funds rate. A change in short term interest rates would start to reshape the investment landscape; however, the Fed is likely to go out of its way to reduce expectations of higher short term rates in the near term. Unemployment is still too high for the Fed’s liking and inflation is a bit too tame.
Higher short term rates could start to change profitability in the banking system, change the investment outlook for holding bonds, and cause traders to rethink the composition of their equity portfolios. To this point, the “zero” rate environment has been an easy reason to be bullish stocks and bonds, although higher short rates don’t need to lead to lower stock and bond prices.
Despite the Fed’s desires, the markets are likely to push the Fed into lifting interest rates. Historically, the Fed has lagged the market in setting policy. Signs of a vibrant economic recovery or rising inflation would cause investors to demand a greater return for holding fixed income assets and push the Fed to adjust policy. In this spirit, the table following highlights the spread between the 2 year treasury note and the fed funds target and the spread between 3 month LIBOR and the fed funds target in the week before the Fed raises the funds target. The data goes back to 1987.
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On a side note, the fed funds target rate was suspended just after the stock market crash in 1987, and nudged slightly higher, 1/8%, in December 1986. This was not accounted for in the table. The spread between the 2 year yield and fed funds target before this snugging was 0.74% the week before the rate hike.
The 2 Year – Fed Funds Spread:
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The Fed has hiked the fed funds when the spread has averaged 1.10%. The largest spread was 1.77% in 2004, while the narrowest spread was 0.94% in 1999. Note the funds rate was hiked 25 bps in four cases, and 50 bps in one case. The spread was 1.24% when the Fed lifted rates by 50 bps.
The current spread is about 0.18% and suggests the Fed is far from lifting the fed funds rate. When the spread gets around 1.00% and the 2 year treasury yields starts trading around 1.25%, the Fed is likely to on the cusp of tighten monetary policy. One could argue that the Fed will move faster this time because of the abundance of liquidity in the system. Maybe, but I’m sticking with the table for guidance. The market knows the liquidity situation just as well as anybody else.
3 Month LIBOR – Fed Funds Spread:
The Fed has hiked the fed funds rate when this spread has averaged 0.42%. The largest spread was 0.84% in 1987, while the narrowest spread was 0.13% in 2004. If the average holds true in the current cycle, 3 month LIBOR would have to be 0.67% for the Fed to lift rates.
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The current spread is near 0% and like the 2 year treasury suggests the Fed is far from lifting the fed funds rate.
Higher rates are not all bad for stocks:
The graphic following displays the relationship between the relative performance of the BKX, KBW Bank Index, to the S&P 500 via the S&P 500 ETF (SPY - ETF report) . There are plenty of periods where bank stocks outperformed the general market when the 5 year treasury yield was rising relative to the fed funds rate. The 5 year yield was used to amplify the rise in interest rates and the market’s pricing of Fed tightening.
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The next chart illustrates the relationship between the 5 year treasury yield and the BKX (banks) outright. Notice that the relationship is mixed over time. Higher rates helped the bank sector between 2003 and early 2007. The direction of rates has also positively correlated to the price of the BKX since the end of the Great Recession. The picture is less clear in the 1990’s.
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The Fed is likely to slow its purchase of long term assets, and will wind down the program in the coming months. However, the action is far from a material tightening of monetary policy and the Fed’s normal policy measures, the fed funds rate, is likely to remain low into 2014.
A change in rate policy will be on the horizon when the 2 year treasury yield and 3 month LIBOR rate start rising in a noticeable fashion. A rise in market rates may be a good indicator of future Fed policy changes. Given history, the markets, not the Fed, are likely to lead the rate hike process. The Fed will test its policy change against market expectations.
Although there is some fear in the stock market over rising rates, the bank sector has been able to benefit from rising rates a number of times. This suggests Fed tightening does not have to derail the bull market.