What comes down must go up

by Pop on March 18, 2010

Post image for What comes down must go up

Is the man in the banner controlling your mind?

This post is partly about the Federal Reserve. I didn’t put that in the headline, because I at least wanted you to get to the first line of the story before falling asleep. By now, I hope you’re committed enough that you’ll read on. That’s called social engineering. And now I’m mixing a poli sci lesson with an economics one. That’s like trying to mask the taste of peas with brussels sprouts. Sorry!

So anyway, every month and a half you probably see a news headline that says something like this: “Fed: Low rates will continue.” I’m guessing that you only have a vague idea of how that’s relevant to your life. Here’s an attempt to explain it.

The announcements are as much about suggestion as they are about action.

Like a really bad boxer, the Fed telegraphs any moves it’s planning to make far in advance. That gives the market time to anticipate a change before having to feel its effects. It’s kind of the same reason pilots tell you to brace yourself for impact before the plane goes down. It softens the blow, if only a little.

That’s why investors spend as much time parsing the language of every Federal Reserve statement as they do caring about what the Fed actually did, and why even a slight word-change can send the stock market soaring or reeling. The Fed doesn’t want to come out and say what it’s going to do, but to suggest what it’s probably going to do. That way, it keeps investors from putting all their chips on one outcome, which would be disastrous for many if the Fed changed paths.

So when Fed members publicly disagree, there might be social engineering at play.

I’m not saying this is happening for sure, but I wouldn’t be the first one to say it. Most of the time, Fed members disagree in private, but keep a united front in public. In the last year or so, several Fed board members have come out and expressed their opposition to the Fed’s official decision.

This could just be a product of the unusual economic environment we’re in. But it could also be a calculated effort to keep inflation fearers happy or to strike fear in the hearts of hedge funds making huge bets about how the Fed might raise rates. Instead of a unanimous board declaring what it’s going to do, you have a divided board that seems like it could tilt the other way sometime soon.

I wouldn’t call this as much a conspiracy theory as a guess that behavioral economics is becoming much more an accepted part of macroeconomic decision making. What you make people feel is just as important as what you make people think.

That said, there’s only one way rates can go: up.

That’s not technically true. The Swedish Riksbank is actually charging a negative interest rate on bank deposits—a tactic the Bank of Japan didn’t even stoop to during its ongoing financial crisis. But so far, that’s not a path the Fed has seemed willing to go down.

Many economists expect the Fed to change its language (i.e. telegraph a rate hike) sometime during the summer and actually raise rates at the end of the year or early next year if unemployment falls. Assuming that happens, what would that mean to you?

For one, it would signal that the Fed feels we’ve pretty much clawed our way out of the recession and aren’t in great danger of falling back in. Ben Bernanke has written papers warning of the danger of cutting off economic stimulus too early. So either he and the governors are satisfied, or some political pressure has fallen on them to move rates against their good judgment.

But that signal will probably have a negligible impact on your portfolio compared to the signal that money won’t be as easy to come by in the future. At higher rates, banks have less incentive to lend money to each other, which means less money is available to borrow and invest. That can have the effect of slowing the economy down, which lowers the premium stock investors are willing to pay for a company’s growth prospects. Of course, in tandem with a Fed announcement, any number of other things can be happening. So you won’t always see a down day in the market when a rate hike happens.

And the same goes for mortgage rates. Mortgage rates are affected by the supply of money in the economy, but there are lots of things that can drive them up or down, including inflation expectations and other government stimulus programs designed to influence rates. That’s why you won’t see a great correlation between Federal Funds Rate moves and mortgage rates.

You will, however, see a pretty big correlation between the Federal Funds Rate and Treasury rates. Generally, when the Fed Funds rate drops, so do bond rates and vice versa. For you, that means a Fed move could bring down the value of your bond portfolio (bond prices move down when interest rates go up), and that’s why many investors have recommended that you tilt your portfolio to short-term bonds that won’t be as heavily impacted.

Anyway, while the Fed didn’t change its rates or its language this time, I hope this helps you digest why your portfolio does what it does when the Fed makes a change.


{ 6 comments… read them below or add one }

Rob Bennett March 18, 2010 at 11:01 am

I hope this helps you digest why your portfolio does what it does when the Fed makes a change.

Your view is the conventional one, Pop. I personally do not share your view about what causes short-term changes in stock prices.

It certainly is true that there have been times when the reaction has been what you describe here. It also is certainly true that there have been times when the reaction has been the opposite of what you describe here. The correlation is often assumed but rarely (never?) demonstrated with convincing research.

I believe that stock prices are in the short term determined by changes in investor emotion. Fed announcements can affect investor emotions. So Fed announcements can have the effect you decribe. But emotions are by definition not rational. So I don’t think we can say that such-and-such change will cause such-and-such reaction. Investors can elect to react precisely in the opposite way from what reason would dictate if they possess some emotional “cause” for doing so.

I don’t believe that it is possible to make sense out of short-term price changes. Emotions are fickle.


Pop March 18, 2010 at 11:25 am

Hi Rob, Thanks for the comment. I actually think I spent most of the post talking about all the ways the markets don’t correlate with Fed announcements. But point noted.

Rob Bennett March 18, 2010 at 12:26 pm

I actually think I spent most of the post talking about all the ways the markets don’t correlate with Fed announcements. But point noted.

Yes. Please don’t think that it is my intent to be critical. My intent is to flesh out the thinking. I like to hit at things and find the weak spots (and thereby also find the strong spots).

It is my belief that we are on the verge of a breakthrough in our understanding of how stock investing works. The people who developed the Buy-and-Hold Model some 40 or 50 years back put us on a path to the discovery of some amazing stuff. I believe that we have allowed ourselves to get pushed a little off track in recent years but I also believe that we are going to work our way back and come to feel great gratitude to all the people who built the foundation.

You do a great job exploring the issues, Pop. I often don’t comment on the many things that I agree with because you have already said them so well. I don’t want anyone to interpret any differing thoughts that I put forward as a criticism of the general blog project. The blog is first rate stuff. It’s one of my favorites.


Craig/FFB March 19, 2010 at 8:38 am

Its interesting you mention social engineering and how the Fed says one thing in their meeting then say something else on their own. I’ve wondered whether our economy has actually gone through a depression and not a recession, but no one would use the dreaded “D” word for fear that people would panic.

BTW, I found the site via GRS and I’ve subscribed to your RSS!

K Smith March 20, 2010 at 11:10 pm

I agree that behavioral economics is part of macroeconomic decision making. But I do not think that the Fed has just recently moved it to the front burner. Those who crafted the act of Congress establishing the Fed understood behavioral economics. They understood that Americans were not behaving the way they wanted them to.

American businesses were relying less and less on banks to fund expansion – they were funding expansion from within out of their own profits. When people aren’t borrowing money from banks, bankers do not make money.

Those who established the Fed were bankers. The Fed was established in 1913 and was designed to eliminate competition. Bankers could now lend money at artificially low interest rates, thus ensuring not only their continued existence, but their assured profitability.

But artificially suppressing interest rates creates a problem – it incentivizes debt. In times of high investor and consumer confidence it creates a demand for debt that would not otherwise exist, resulting in economic booms fueled by debt bubbles.

When the bubbles deflate – when people realize that the inflated asset prices fueled by the debt have no basis in reality – the value of the assets backed by the debt collapse. It is not a pretty sight, as we all experienced with the collapse of the housing market.

As long as rates continue to be artificially suppressed, the booms and busts become progressively more pronounced over time. This is becasue the system is designed so the debt never really gets paid off. It just gets shifted to another asset class. This results in cycles in which banks make money during the booms, and then get bailed out by government during the busts – with the taxpayer picking up the tab.

I believe Craig/FFB is correct. We are in the midst of a second Great Depression. Unless the power to artificially control interest rates is eliminated, the boom and bust cycles will continue, and our children and grandchildren are in for more of the same.

Behavioral economics is not only now becoming a more accepted part of macroeconomic decision making. It has been the basis of the boom and and bust Fed system since day one.

darryl June 12, 2010 at 11:05 am

When was the last time you saw an emotional investor buy more bonds when interest rates have been announced to go up?

Say no more!

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