The Fed has only three options at its disposal: (1) cut interest rates, (2) guide market expectations, or (3) launch QE4

FWIW The Fed has only three options at its disposal: (1) cut interest rates, (2) guide market expectations, or (3) launch QE4 by WORTH WRAY / Chief Economist, EverGreen GaveKal

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“Money is too much a serious matter to be left to central bankers.”
– Milton Friedman


– Last week’s fed funds rate hike may be the first in nine years, but the Federal Reserve has effectively tightened US monetary conditions over the last 18 months by roughly 325 basis points. It’s already more than the Fed tightened during the 1990s.
– Considering how much the Fed has already tightened, and how the US economy seems to be losing momentum on several fronts, we may be much closer to the next recession than most investors believe.
– In the event of a 2016 recession, the Fed has only three options at its disposal: (1) cut interest rates, (2) guide market expectations, or (3) launch QE4.
– While the Fed may be able to dampen the effects of the next recession with hot air, negative interest rates, and massive QE, overvalued US equity markets may be in for a rude awakening between now and then.
– Investors will have the opportunity to rotate into more aggressive, equity-heavy portfolios with attractive yields and compelling valuations. Until then, my colleagues at Evergreen GaveKal and I prefer defensive, equity-light portfolio allocations with large cash reserves and modest collections of beaten-up, high-yielding assets that are already priced for bad outcomes.


By Worth Wray, Chief Economist

Tapering is Tightening. Forget what you’ve seen on CNBC or read in the Wall Street Journal about last week’s rate hike heard ‘round the world.

Figure 1

Since the summer of 2013, the Federal Reserve has curtailed the markets’ once open-ended stimulus expectations, it’s tapered its QE3 asset purchases down to zero (green line in chart at the top of the next page), and now it’s hiking interest rates (white line in the chart below).


Last week’s Fed hike may have been the first in nine years (with obvious parallels to the central bank’s premature tightening in 1937), but – as the Atlanta Fed’s Shadow Fed Funds Rate suggests – the central bank actually started tightening more than eighteen months ago.

While common knowledge tells us to worry about the last hike instead of the first one, this time truly is different than every other initial rate hike in US history.

In the chart below, the federal funds rate (green line) gave investors and policymakers a clear view on how easy or tight Fed policy was in the years before 2008; but when the Fed dropped its fed funds target to the 0% to 0.25% range in December 2008, it failed to reflect any subsequent changes. Monetary conditions varied substantially over that period, and yet the Fed’s rate target remained the same.

That’s where the shadow fed funds rate (white line) comes in. As you can see in the chart below, it gives us a much clearer look at Fed policy below the zero bound by showing how unconventional policies like QE1, QE2, Operation Twist, and QE3 effectively eased monetary conditions and how shrinking and/or ending those programs has effectively tightened monetary conditions… despite the fact that – until just last week – the fed funds rate has remained at zero for the past seven years.

FED TIGHTENING CYCLES SINCE 1990EVA2_001Source: Evergreen GaveKal, Bloomberg

As you can clearly see, tapering is tightening and the Fed has been tightening for quite a while. Look no further than the foreign exchange and bond markets if you have any doubt.

As you can see in the charts below, the widening of credit spreads*…


… the rise in the US dollar  (white line below), and the deterioration of US financial conditions (green line below) has perfectly coincided with the tapering-off of QE3.


That means that combined with last week’s 25 basis point (0.25%) fed funds hike, the Federal Reserve has already effectively tightened by 325 basis points (for the lay reader, that’s 3.25%) since mid-2014. We’re talking about 25 basis points more than the Fed tightened throughout the entire 1990s and roughly 75% of the entire tightening move from 2004 to 2006. From this perspective, either the Fed is in the middle of one of the greatest tightening efforts in modern history, or it is almost tapped-out with short-term rates barely above zero.

Stick with me, because this has enormous implications for the US economy, global financial markets, and your personal portfolio.

*The difference between corporate bond yields and the yield on US Treasuries of comparable maturities.

Almost a third of the world’s active investors are too young to have experienced a Fed rate hike, but no one has ever seen anything quite like this. While the majority of investors are operating as if the Fed is just beginning to tighten, we may be a lot closer to the next recession than the Fed admits or the general public realizes.

The Smell of Bankruptcy. While the Fed sees continued improvement in the US labor market – with unemployment (white line below) now arguably at or below its target level despite elevated underemployment (gray line below) – as cause to signal further tightening in 2016…


…and sees weak inflation readings as the temporary product of low oil prices (gray line below) and a strong trade weighted dollar (white line, inverted to show its impact on inflation and oil prices)…


…it’s worth considering if the Fed is actually too late in hiking interest rates after the most aggressive easing cycle in modern US history (830 bps from 2007 to 2014, as we discuss a little later).

Yes, unemployment is low, but it may be too low considering the logical impact of the global financial crisis, the retirement of Baby Boomers now in their mid-to-late-60s, and the labor-displacing effect of rapid technological change. If that’s true – if the natural level of unemployment is now closer to 6% or 7% as opposed to 5% – then it’s very possible the Fed has over-stimulated the economy once again.

QE1 and QE2 were necessary evils in saving the country from a Great-er Depression scenario, but the decision to use emergency tools and open-ended forward guidance in an attempt to fine-tune economic growth with QE3 may prove to be the biggest policy error in decades.

Just consider where all (or at least a lot of) those construction workers from Greenspan’s housing bubble went after the global financial crisis. Many of them went to work in shale fields in places like Texas and North Dakota…