Don’t Pay TOO MUCH Attention To The Fed! by Joao Alves, Ahead Of The Crowd

“Every great magic trick consists of three parts or acts. The first part is called “The Pledge”. The magician shows you something ordinary: a deck of cards, a bird or a man. He shows you this object. Perhaps he asks you to inspect it to see if it is indeed real, unaltered, normal. But of course…it probably isn’t. The second act is called “The Turn”. The magician takes the ordinary something and makes it do something extraordinary. Now you’re looking for the secret… but you won’t find it, because of course you’re not really looking. You don’t really want to know. You want to be fooled. But you wouldn’t clap yet. Because making something disappear isn’t enough; you have to bring it back. That’s why every magic trick has a third act, the hardest part, the part we call “The Prestige”.”  — John Cutter, ‘The Prestige’

Fed
Photo by KJGarbutt
Fed

Setting the Stage: Sentinel or Illusionist?

Trying to predict the actions of the Fed is an exercise in futility for value-oriented investors.

Throughout 2016, the question of a possible Fed rate hike flooded the media. Yesterday’s meeting signaled that a hike is eminent by the end of the year. However, should we all waste precious time and energy debating the timing and extent of this probable event? Fight the Fed…don’t fight the Fed…this is a ceaseless debate that comes at expense of studious discussions about the real issues that matter.

On this note, I feel it’s a good time to explore a serious misconception about the relevance of the Fed.

The ignorance I’m referring to is the belief that the Fed conducts the functioning of the financial markets through their command of long-term interest rates – a statement of two parts, both of which are false. The Fed doesn’t control the markets, and it has no direct control over the movements of long-term rates.

Thanks to a few very thoughtful and respected investors* who have shared their wisdom, these truths are slowly becoming ubiquitous. The broader market is learning about the true relevance of the Fed, the anatomy of macroeconomics and how both are practically linked by the behavior of markets and its participants. The result of which may hopefully be a more cautious optimism and skepticism as to the real risks to global markets.

“The Pledge”

In order to understand how the Fed is associated with rate movements, some macroeconomic mechanics must be understood.

Just as interest rates affect inflation, the expectation of inflation affects interest rates. And because one of the Fed’s key purpose is to monitor inflation (prices of goods/services) in the US, people tend to think that they must also have control over interest rates. This is a fallacy. Interest can’t be created or set by a single entity. Interest rates are set ex-post by members of the real economy (banks, other businesses, investor sentiment and expectations, etc.), who act on behalf of expected economic growth in the economy and expected inflation.

The Fed’s only lever of decision making in the real economy is the setting of the target Fed Funds Rate. This range of a target rate is direct at banks, whose decisions directly affect the markets and the real economy as they are the foremost providers of credit. Nevertheless, this only has a significant impact on short-term interest rates, which shows how inadequate this belief is for investors with long term horizon.

The only influence that the Fed has over long-term rates is the fact that their policy and commentaries on the economy send signals that may dictate the actions of market participants due to the credibility that the Fed holds in the global marketplace. Interest rates movement may or may not run in course with the Fed’s policy. Therefore, the setting of interest rates is a blend between market forces and Fed intervention. This understanding is of paramount importance for intelligent investing.

Personally, I think people place too much value on the Fed’s views/evaluation of the economy. They should be one of many sources of information, not the Dalai Lama. People believe that the pedigree that fills the walls of the Federal Reserve banks equate to superior analytical minds and magical foresight. They have faith in the integrity and rigor of the Fed. But, what happens if even one of these premises is faulty from the start?

“The Turn”

Nonetheless, it’s important to explore the tools at the disposal of the Fed that can manipulate interest rates. The two main ones are the following:

1/ The first one refers to the Fed Funds Rate, an interbank rate at which banks and other depository institutions lend/borrow funds that they hold at the Federal Reserve to each other overnight (short-term). The setting of a target for this rate sends a signal about the Fed’s view of the economy.

  • For example, if the Fed raises the Fed Funds Rate, the indication sent to the market is that the Fed thinks that the economy is strong and possibly overdue in its expansion, as viewed perhaps by high inflation. A high rate affects the supply of reserves of banks, and would discourage them from lending to each other as it becomes more expensive to do so. This could consequently affect business activity given that businesses might dispense borrowing as they would have to pay higher interest on their loans. This would slow down the economy and push down inflation. Investors then end up resetting expectations and adapting.

2/ The second way in which the Fed indirectly affects interest rates is through the purchase or sale of government bonds. This activity has two important effects that in turn, affect interest rates: it shakes (a) the amount of money held by banks in their reserves, and (b) the supply/demand dynamics of the bond market. Let’s explore the example of quantitative easing, whereby a central bank, let’s say the Fed, purchases government securities in an effort to increase the supply of money and promote economic growth when the economy stalls:

  • The money spent by the central bank in the purchase of those government securities would be credited to the reserve accounts of banks, which means that the banks would have more money to lend and thus more willing to do so. The effect of this on business activity and consumption is that it would lower interest rates as the reserves of banks have swollen up and they have less need to borrow money from one another, instead using their money to invest in riskier assets. This in turn affects businesses and consumers who are encouraged to stop saving and start investing and spending.
  • When the Fed buys a security, it does so from an investor (banks, institutions, etc,), who will then use that money to invest in something else. In a more explanatory note, the idea is that by lowering the supply of bonds through purchasing, and simultaneously increasing the demand for them (accounting for the credibility that the market places up the Fed’s decision-making ability and its intellectual capital), the prices of those bonds go
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