The Fed is in Charge of the Punchbowl

2019-04-02 | TG Watkins

I am sure we have all heard the phrase “don’t fight the Fed”, but do we really know what that means?

For good or bad, the Fed dictates monetary policy and market operators have learned to use those reports as guidance for whether to be putting money into risk-on or risk-off (stocks vs bonds respectively). Some would say the Fed has too much influence over what should be the free market, but it has been this way for a long time and really, we are giving them the power by using their reports as such guidance.

It could be viewed as a self-fulfilling prophecy, but it also makes sense that if monetary policy is tight it is a bit more costly to put money to work and therefore, a small punchbowl has to go a long way. When the economy gets in trouble the Fed steps in with a shiny, fresh, bigger punchbowl. Oh, and it’s spiked. This is them loosening monetary policy namely by reducing interest rates which makes it cheaper/easier to borrow money and make business happen.

We have seen this tactic many times over the last few decades and for the most part it works. However, an interesting phenomenon has been occurring in recent years: keep the punchbowl around for too long and when you go to take it away, the party-goers start to throw a big fit. The most recent example of this was the October 2018 drop when the market realized the Fed was going to march interest rates up every few months no matter what. Maybe it was too much in too short of a period, but we are currently at 2.5% which could be argued is still low compared to historical norms.

The Fed knows this, and they also knew they needed to get rates back to “normal” otherwise when the economy inevitably sputtered again, they couldn’t spike the punchbowl because everyone is still drunk from the last one. So they got themselves between a rock and hard place: raise rates back to normal but have everyone fall on the ground and throw a tantrum, or leave rates as they are and have no way to jazz the party back up when things get slow.

For now, the Fed seems to have managed a middle road to appease the party-goers with a 2.5% interest rate and a promise they won’t raise it any further in the near 2019 future.

Fed rate SPY chart

This compromise leaves a few questions remaining:

  • Why did the market throw such a tantrum when rates began to rise?
    • Was it too much too quickly?
    • Was the market used to having interest rates so low for too long?
    • Is the underlying economy not strong enough to handle the higher rates?
  • With the rate already at 2.5%, will a reduction be as effective when the Fed needs it?
  • Should the Fed have raised rates sooner but more gradually?

These questions probably won’t be able to be answered until they are answered; which is to say we won’t know until life is lived and the data is in the record books. The only thing we can do, like in trading, is look to the past to help guide us forward.

The Fed kept rates at effectively zero for 7 years then decided to raise them 2.25% in 3 years. I am not alone when looking at the Fed’s actions and wondering if they got caught with their pants down and they realized they needed to hurry up and get rates back to a more historically normal level.

So as they say, don’t fight the Fed. And for now, the Fed is friendly to the market again and everyone knows it for 2019.

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