VOL. 129 | NO. 250 | Wednesday, December 24, 2014
The Worldly Investor
Don’t Be a Hero, Leave Rates at Zero
By David S. Waddell
As if we needed further evidence that investment markets price off of central bank soliloquies, markets worldwide rallied 4.5 percent last week in reaction to a short press release from the U.S. Fed.
As the year comes to a close, Wall Street strategists have begun forecasting for 2015, and while expectations overall are bullish, the variance in projections hinges on expectations for the timing and degree of Fed rate hikes. So what should the Fed do?
Remember that the interest rate yield curve expresses two opinions. The Federal Reserve controls the short-term price of money through establishing the overnight rate, while the marketplace sets prices at the long end. The Fed took overnight rates to approximately zero on Dec. 16, 2008, and has held them steady since.
In early 2010, the marketplace, recognizing economic recovery, pressed 30-year Treasury bond yields to 4.5 percent. By mid-2012, deflationary fears pulled this rate down to a historic low of 2.58 percent, near today’s rate of 2.81 percent. The long end of the yield curve factors in many inputs, but relies primarily on inflation expectations.
One way to measure real marketplace inflation expectations is to compare yields on five-year and 10-year Treasury Inflation Protected Securities and ordinary Treasurys. This measure reflects market inflation expectations for a five-year period, five years in the future. Today, this measure registers 2.08 percent, having fallen in the last three months to its lowest level since the echo-crisis of 2011. In other words, while the Fed has expressed its concerns over future inflation risks … the marketplace sees no future inflation risks.
The Fed, therefore, finds itself in a curious predicament. While the economy and labor market in the U.S. have strengthened significantly, price levels have remained pallid. Although the Fed extinguished its QE program in October, long term interest rates have fallen post-QE.
The Fed’s dual mandate of full employment and price stability requires that both be met. The labor market may now require less stimulus, but the price environment may actually require more. Hence the motions of ex-U.S. central banks to cut rates and increase QE. No doubt the Fed recognizes this conundrum. Talking about raising rates makes sense to contain excess speculations. Actually raising rates makes no sense until inflation arrives in earnest.
Bottom Line: The Fed revived the bull market last week by talking down fears of interest rate hikes. Seen in isolation, the conditions in the U.S. might warrant higher rates, but in the broader context of sluggish ex-U.S. economic and price conditions, the case for higher rates diminishes.
Undoubtedly, the U.S. will be the first major economy to raise rates as we addressed our post-crisis issues sooner and more forcefully than our global partners. However, jumping too far ahead creates unintended consequences like the kind of currency, commodity and marketplace volatility we have recently seen.
In our view, the Fed should manage the message but leave rates anchored while monitoring broad inflation gauges and ex-U.S. central bank policy measures. At this point, the risk of doing something exceeds the risk of doing nothing. Don’t be a hero, stay at zero!
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.