FOMC & ZIRP; What They Do, Not What They Say

The reason we took QE tapering seriously was that it made sense at a certain point of economic recovery for the Fed to start backing out of the market pumping business of printing money to fund T bond and MBS purchases.  With traction gained in the economy, my thought was that now it might be time for rising  interest rates out along the curve to incentivize banks to do the heavy lifting, as ZIRP on the Fed Funds level pinned T Bill yields to the mat.

It was the old ‘borrow free and mark it up for a slam dunk carry trade’ routine.  In short, the people bailed out the banks and now the banks can lend back to the people and make even more money doing it.  Nice racket, with the Fed at your back.

So it seemed there was a valid scenario in play whereby the Fed could make good on the rumors of a coming QE taper and as it turned out, they did just that.  They initiated and are now carrying through to the closing phases of the ‘taper’, with markets and the economy doing just fine after all that doomsday hype in the second half of last year.  To boot, 10 year T bond yields have actually declined by about a 1/2% in 2014 despite the Fed tapering out of the bond buying business.

10 year yields are down in 2014, but may be sneaking out the downtrend

So in 2013 some Fed members ruminated in the media (they Jawboned) a coming taper of QE and sure enough on it came.  Today, the market is left to decide whether or not they are serious about raising the Fed Funds rate sometime in 2015.  The dot plot has them guiding us to 3.75% out in 2017.

Dots… from the Fed

Should we take this seriously (I for one would love to see it happen so that Grandma can make some income on her passbook savings account again)?

Well first let’s consider that markets often continue upward in-line with increasing Fed Funds/T Bill yields.  It’s the way it usually works in semi-normal markets.  So theoretically, the market has nothing to worry about for the next couple of years.

But we’ll reintroduce the chart we’ll call ‘Mr. S&P 500 with the duel inputs of a Money Supply hockey stick and ZIRP’, which is approaching its 6th anniversary.

Source: SlopeCharts

All current trends in the lines above were born in Q4 of 2008 to Q1 of 2009.  With QE tapering nearly complete, we might expect money supply to flatten out again.  I say ‘might’ because if this aggressively managed market environment has taught us anything, it is to realize that assumptions are just those, assumptions.

While we are on the subject, here is another assumption.  We might assume that the market will climb the Wall of Worry about rising Fed Funds interest rates as it usually does.  But our long-held theory is that distortions were mainlined into markets beginning in 2008 with the various direct bailout plans, ZIRP and on through QE’s 1, 2 and 3 (with a side order of the ‘inflation sanitizing’ Operation Twist to boot) paving the way for future dysfunctional behavior.  The kind of dysfunction that gold bugs are already being punished by.

Source: SlopeCharts

Until another distortion hit gold in the form of a mass flight into the precious metal (resulting in an upside blow off) during the Euro crisis, gold had dutifully protected people against the currency compromising combo of ZIRP and QE.  It is now unwinding, with a potential (please respect the word “potential”, we don’t make titillating predictions here, we simply manage markets effectively) target back down to the birthplace of so many of today’s market signals; the 1000 +/- area support from 2008-2009.

Is gold forecasting the stock market’s eventual fate?  Well, it certainly preceded the stock market to the upside during what we called the Age of Inflation on Demand (2001 to 2007, with a reprise from 2009 to 2011).  With a stronger US dollar (see A Closer Look at the USD) I don’t think we have to worry about interest rates rising any time soon at the Fed Funds level.  Gold, commodities and the US dollar are forecasting a complete lack of inflationary pressures.

The Fed can show us its dots and make its projections, but the macro says that they’ve got a mandate to continue to hold ZIRP for as long as they want.  The problem is that policy has drawn the world into US assets and hence, the US (reserve) currency (in essence, providing the service that gold used to provide).

But a persistently strong currency can be expected to wear away at the manufacturing sector and other industries that depend on exports.  The heavily financialized economy may appear fine for some time to come, but we should watch its non-financial components.

My sense is that yesterday’s FOMC, with its dots and its projections was, unlike the coming of QE tapering (which was always viable) just a Kabuki Dance for the market’s expectations.  They have built something that has taken on a life of its own and the assumption is that it will play out to its logical extension.  But gold had a logical extension as well.  It was supposed to go up amidst money printing and a vertical money supply.  The indication is that these things tend to fall apart.

I don’t think the first Fed Funds rate increase, if it even takes place, is going to have any bearing on events.  Right now the Fed is noise but the macro, led by the strong dollar, will probably take care of itself.  The S&P 500 has a blueprint in the form of gold and commodities.  Watch the US dollar and tune out the Fed Funds interest rate hype.

I realize this article has little in the way of conclusions.  It is a consideration piece, not market analysis.  We have enough intellectualizing going on out there, chasing every detail in a dysfunctional macro environment.  Sometimes it’s good to just write and see where things end up, like a brick wall for example.