According to the ever powerful Wikipedia, tasseography (aka tea-leaf reading) traces back to medieval European fortune tellers who developed readings from splatters of wax, lead, and other molten substances. Over the years, economists, analysts, and the media often feel like tea leaf readers when decoding the language used in memos and speeches from Federal Reserve members, searching for hints of the next policy move. Yet this Fed has been quite transparent about its plans, though not everyone believes them this time.
Last week, John Williams of the San Francisco Federal Reserve Bank was interviewed by the Financial Times. It is a great interview I recommend to all readers. This quote stuck out to me:
“Say the Fed were to raise interest rates later this year, a few times and over the next year or so, interest rates would be above zero, and say the economy slows relative to our expectations and progress on our inflation mandate slows. Well obviously we can slow down the process of raising interest rates. We can even pause for a while, not raise interest rates further. We have a lot of degrees of freedom to adjust our policy dependent on how circumstances develop. It is really important to remember though that monetary policy does work with a lag. Typically our models, our analysis, tells us it takes us a year or two to have a full effect on the economy and inflation.
So let me randomly pick a date out of my head. Say middle of 2015 you started just removing accommodation, well the effects of that on inflation really wouldn’t be felt until mostly until the middle of 2016 or maybe 2017 given the lags in monetary policy.”
Source: CME Group FedWatch, as of 2/19/15
Many large investment firms whose research we still follow have been notoriously wrong at predicting interest rates the last several years. Why bother read it you may ask? Well, to get a feel for what the majority of folks may be thinking. Writing an opinion is easy, it’s best to look at where traders placed bets in the Fed funds futures market (chart above). Investors believe there is an 82% chance that the Fed hikes rates by the end of the year, with the slight majority believing at the last meeting rates will be at 0.75% (from a 0 to 0.25% range today).
In anticipation of the move, the change in interest rates followed similar patterns to previous hiking cycles. While short-term interest rates increased (the 1-5 year maturity area), longer term maturities (of the 10 and 30-year variety) actually decreased in yield.
The expansion of the business cycle reached its 68th month as the previous recession ended in June 2009, making it the fifth largest all-time since 1857. The chart above demonstrates that cycles are living longer than previous expansions, as each of the previous three made it over 6 years. We would attribute this to the growth and availability of credit. While many cite the lack of credit expansion in this cycle as holding it back, banks are in the midst of loosening standards while demand for credit is increasing at the margin. Still, we should keep this chart handy as the signaling of interest rate hikes marks a key line of demarcation from accommodative monetary policy to tightening policy.
Many of the bond fund managers we use within portfolios forecasted the Federal Reserve’s intention of interest rate hikes in 2015, including Doubleline’s Jeff Gundlach and Guggenheim’s Scott Minerd. In his note last week, Minerd keyed on St. Louis Fed President James Bullard’s outspokenness on policy over the past few years, including lately. He wrote, “Whenever ‘lift off’ actually occurs, we’ve been long anticipating this day would come…. The good news is there is still time [for investors] to prepare for when the Fed finally runs out of patience.”
Interest rates seem to be reacting to this rhetoric, and so far closely following an analog to the “Taper Tantrum” in 2013 (when then Fed Chairman Ben Bernanke uttered the word ‘taper’ in regards to the quantitative easing program).
No central bank has been able to get off the 0% floor, that is, raise rates once the policy rate has been at the lower bound like it has been in the U.S. for the past six years. Investors will be reading the tea leaves from the Fed closely, as removing accommodation will likely bring volatility to capital markets.
For more information, please contact Aurum Wealth Management Group at 440-605-1900 or visit our website at aurumwealth.com. To stay up to date with the latest investment-related news, follow us on Twitter @aurumwealth and sign up to receive our free newsletter.
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.