This Won't Be the Fed That Slays the Bull Market

With Fed funds at 1.55% and the Federal Reserve pumping money into the repurchase agreement -- or repo -- market, it probably feels like the Fed is being quite active. Indeed, even within the Fed, there is disagreement about what 1.55% Fed funds means. In the minutes from the December meeting, a few participants argued about the risks of keeping rates low over a long period of time. But I'm here to argue this is the most hands-off the Fed has been in a long time, perhaps in my whole 20-plus-year career trading bonds. The Fed officials worried about keeping rates low need to consider what we mean by low in today's economy. Clinging to outmoded ideas of what normal interest rates are will only lead to investing mistakes. 'Normal' Is No Longer a Helpful Concept The Fed has commonly used the term normalization to describe policy moves in recent years, including rate hikes from 2015-2018 and the draining of the balance sheet starting in 2017. But I think using normal in this case has caused confusion. When we use that word in everyday speech, the word is synonymous with common or typical or natural. And by extension, if something needs to be normalized, it stands to reason that the current condition is unusual or unnatural and probably won't last. In the case of interest rates, the concept of a normal rate implies that today's rates are too low. It also suggests that rates are naturally pulled toward this normal level like an object is pulled by gravity. Rates can evade gravity as long as some other force is acting upon on it -- like the Fed -- but once that force is gone, the natural order will reassert itself. How Do You Know Rates Are 'Low'? In my quote above from the Fed minutes, a group of members is asserting that rates are low. But of course low is a relative term. The current level of Fed funds is below the 30-year average, but above the 10-year average. It is below the level that persisted during the last expansion, but is above most other developed market central bank rates. So are rates high or low? Depends on what your comparison point is. Let's rephrase the high/low question into something more directly relevant: Is current Fed policy loose or tight? Really, this is the question that actually matters, and it helps get us away from just comparing current rates to history. In reality, interest rates are too low if policy is too loose and vice versa. And ultimately this is the case that the hawks within the Fed are making. When they say that keeping rates low over a long period of time creates risks, they are really referring to keeping policy too accommodating over a long period of time. So how would we know if policy is too accommodating? If we broke out a Macroeconomic textbook from the 1990s, it would say that policy is too accommodating if it is causing inflation. In other words, if we went back to a time when a Fed target at 4% might have been loose or might have been tight, the way you'd know is if inflation were accelerating. It isn't any different today. Inflation isn't accelerating, therefore money isn't loose. Risk Management Is Still in Force To be fair, monetary policy operates on long and variable lags. So, it is certainly possible that inflation pressures that are building now will show themselves in the coming months. But this is a risk the majority of the Fed is willing to take. The risk it isn't willing to take is that tight money causes a recession. Remember that the rate cuts from 2019 were generally characterized as risk management, meaning, the Fed didn't think we were in a recession, but wanted to head it off before it happened. It knows that with rates as low as they are, the Fed probably lacks the firepower to fight a recession should one come. Therefore, it is going to do anything it can to avoid getting there. While the Fed no longer sees the need to actively cut rates, the risk management mentality remains. It wasn't just that it's worried about the particular signs of slowdown we saw in 2019. It is worried about the broader problem of fighting another recession. This worry isn't going away just because the 2019 slowdown threat seems to be now diminishing. It is more or less a permanent condition. If you follow that logic, I think there is an inescapable conclusion. It is highly unlikely the Fed is going hike until after the next recession hits. While there is a small chance that at some point we have an inflation problem, global conditions just don't seem to favor such an outcome. As Fed Chair Jerome Powell has said himself, the link between wage growth and broad consumer inflation seems to be broken. At this stage, the only case you can make for inflation accelerating is a ya never know case. So if inflation doesn't accelerate, the Fed is on hold until it's cutting again. If we assume that a recession is coming eventually, then we should also presume the Fed gets to zero (or close to it) at that point. Only during a subsequent recovery does it make sense to expect a hike. If Economy Is Growing, Fed Should Be Hands Off As the old adage goes, bull markets don't die of old age, the Fed kills them. The Fed is going to try very hard not to kill this bull market. If it dies, it will die on its own or because of some exogenous force. At no other time in the last 20 years could we say such a thing so confidently. During every other expansionary period there has always been a looming threat of Fed hikes, and particularly, that at some point Fed hikes could go too far. That threat is gone.

This Won't Be the Fed That Slays the Bull Market

Clinging to outmoded ideas of what is 'normal' and even what is 'low' will prevent you from seeing just how hands-off this Fed really is.

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