The Ides of March Approach

In my previous post, I ended with the words, “Beware the Ides of March.” Well, if Janet Yellen and her friends on the Federal Reserve are to be believed, the Fed will raise interest rates on that day, and maybe several times after that later this year. Which leaves us with the uncomfortable thought of what happens to the bull market in stocks – and bonds, for that matter, too – that has been running virtually without interruption since the Fed dropped rates to zero back in 2008. Can the bulls continue to run without that prop?

If there were still any lingering doubts that the Fed would raise rates at its meeting next week, Yellen pretty much put those to rest in her speech in San Francisco last Friday. “At our meeting later this month, the [Fed’s monetary policy] committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate,” Yellen said, adding that “the economy has essentially met the employment portion of our mandate and inflation is moving closer to our 2% objective.” That speech followed similar comments from several other Fed officials during the week.

The week earlier, the bond market couldn’t seem to get through its head that the Fed wasn’t going to wait until May to start raising rates, so it took a virtual parade of Fed officials, one after another, to drive the point home last week, capped off by Yellen’s speech. The yield on the three-month Treasury bill rate, which traded at just about 0% from 2009 to 2016, shot up 20 basis points to close at 0.70%, its highest level in nearly 10 years. The market’s odds for a March hike are now at 90%.

Should we be worried? Yes. How much? A lot, I think.

In normal times, the strength of the economy generally drives the financial markets and stock prices. It makes sense – if the economy does well, businesses will do well, and that will be reflected in stock prices.

Yet, over the past nine years we’ve had a roaring bull market in stocks, in which the major indexes have more than tripled, and in bonds, in which the yield on the benchmark 10-year Treasury note dropped from about 5% in May 2007 to as low as 1.50% (it closed last Friday at 2.49%). And over that time the economy has basically limped along at about a 2% annual growth rate, the slowest economic recovery since World War II, as many observers like to point out.

What fueled those twin bull markets in the absence of strong economic growth, and in the presence of strict government regulations that have stifled that growth? Why the Fed of course. In addition to holding the federal fund's rate at near zero for nine years, it also ballooned its balance sheet from about $1 trillion before the financial crisis to $4.5 trillion currently, where it accounts for more than 22% of the total outstanding federal debt of $20 trillion. That not only drove bond prices up and long-term interest rates down, it also pushed investors out of the relative safety of the Treasury bond market and into risk assets like stocks, boosting equity prices.

And now it looks like the Fed is going away.

While we can hope that the Fed will be nuanced enough to gradually tighten monetary policy in such a way so as not to upset the markets, we don’t know that it can do that. If the Fed was in unchartered territory when it started the whole process of zero percent interest rates and super-accommodative monetary policies, it’s in equally unchartered territory now, trying to stuff the genie back in the bottle. Whether it can finesse its way back to a more normal financial marketplace, we simply don’t know – and should have some doubts.

While the Fed is certainly good at creating financial bubbles, it has little experience in retreating from such a massive dose of easy money. How exactly will the Fed raise rates to fight off inflation and what it fears is an “overheating” economy, and start selling off its massive bond portfolio, while not creating panic selling in the equity and bond markets? I guess we’ll find out.

We now have to hope that the Trump Administration will be successful in boosting the economy enough to mitigate any possible disruption from tighter monetary policy.

But that’s an equally big question mark. While the stock market’s behavior since November 8 indicates that there are a lot of believers, we don’t really know if what Trump wants to do – lower tax rates, roll back Dodd-Frank, repeal and replace Obamacare, boost military and infrastructure spending – will come to pass, and if they do, they will boost economic growth as envisioned.

So here’s the quandary before us. Over the past eight years, the Fed had President Obama’s back, doing whatever it could think of to boost economic growth, with little in the way to show for it. Now we have the specter of the exact opposite happening – President Trump basically bailing out the Fed from its years of mistaken monetary policy. What are the odds on that happening?

Visit back to read my next article!

George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.