Pulling the Band-Aid Off Slowly

May 21, 2016 at 10:21 pm Leave a comment

Bandaid

Federal Reserve monetary policy once again came to the forefront as the Fed released its April minutes this week. After living through years of a ZIRP (Zero Interest Rate Policy) coupled with QE (Quantitative Easing), many market participants and commentators are begging for a swifter move back to “normalization” (a Federal Funds Rate target set closer to historical averages). The economic wounds from the financial crisis may be healing, as seen in the improving employment data, but rather than ripping off the interest rate Band-Aid quickly and putting the pain behind investors, the dovish Fed Chair Janet Yellen has been signaling for months the Fed will increase rates at a “gradual” pace.

Despite the more hawkish tone regarding the possibility of an additional rate hike in June, Fed interest rate futures are currently still only factoring in about a 26% probability of a rate increase in June. As I have been saying for years (see “Fed Fatigue”), there has, and will likely continue to be, an overly, hyper-sensitive focus on monetary policy and language disseminated by members of the Feral Reserve Open Market Committee.

For example, in 1994, despite the Fed increasing target rates by +2.5% in a single year (from 3.0% to 5.5%), stock prices finished roughly flat for the year, and the market resumed its decade-long bull market run the subsequent year. Today, the higher bound of Fed Funds sits at a mere 0.5%, and the Fed has announced only one target increase this cycle (equaling a fraction of the ’94 pace). Even if investors are panicking over another potential quarter point in June or July, can you say, “overkill?”

While the Fed is approaching the lower-end of the range for its employment mandate (unemployment currently sitting at 5%), despite the recent bounce in oil prices, core inflation remains in check (see Calafia Pundit chart below). This long-term benign pricing trend gives the Fed a longer leash as it relates to the pace of future rate hikes.

Source: Calafia Beach Pundit

Source: Calafia Beach Pundit

Sure, ripping off the Fed Band-Aid with a small handful of +0.5% (50 bps) hikes might appease hawkish investors, but Janet Yellen, the “Fed Fairy Godmother,” has made it abundantly clear she is in no hurry to raise rates. Whether there is zero, one, or two additional rate hikes this year is much less important than other fundamental factors. Adding fuel to the Fed-speak fire in the short-run will be Yellen speeches on May 27th at Harvard University and on June 6th at the World Affairs Council of Philadelphia. And then following that, we will have the “Brexit” referendum (i.e., the vote on whether Britain should exit the EU); a steady stream of election noise; and many other unanticipated economic/geopolitical headlines.

As I continually state, the key factors driving the direction of long-term stock prices are profits, interest rates, valuations, and sentiment (see Follow the Stool). Profits (ex-energy) are growing near record levels; interest rates are near record lows (even with potential 2016 hikes); valuations remain near historical averages; and sentiment regarding stock ownership is firing strongly as a positive contrarian indicator.

While many pundits have been calling for and predicting the Fed to rip the Band-Aid off with a swift string of rate increases, persistently low inflation, coupled with a consistently dovish Fed Chair are likely to lead to a slow peeling of the monetary policy Band-Aid. Unfortunately, the endless flow of irrelevant monetary policy guesswork regarding the timing of future rate hikes will be more painful than the actual hikes themselves. In the end, any future hikes should be justified with a stronger economic foundation, which should represent future strength, rather than future weakness.

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www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

Entry filed under: Earnings, economy, Financial Markets, Interest Rates, Themes - Trends. Tags: , , , , , , , , .

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