While attending one of my son’s downhill ski races over the weekend, I found myself riding the chairlift back to the top of the hill listening to the fifth Taylor Swift song in a row, blaring from the loud speakers. I thought, isn’t it possible that we’ve had too much of Taylor Swift? I mean she is everywhere on country and pop radio and has been for many years. And that had me thinking about last week’s news from central bankers, here in the U.S. and abroad. Both the Federal Reserve and the Bank of Japan made statements last week that moved markets. As a result, their policy decisions and statements dominated headlines and investors’ thoughts again!
TAYLOR RULE
The Taylor Swift connection isn’t only about the overexposure both she and central bankers have. It also has to do with the Taylor Rule. While this rule has nothing to do with the country/pop artist by the same name, I am sure her followers would believe she is powerful enough to control interest rates. In fact, the Taylor Rule is named after John Taylor, a Stanford economist who created it to describe the relationship between the level of the Federal Funds rate (set by the Federal Reserve), inflation and economic growth. Basically, his formula says that the Fed Funds rate will equal 2% when inflation is at the Fed’s target of 2% and economic growth is at its full potential. This could be considered economic equilibrium. We know that the Fed Funds rate is currently .25%, after being raised from zero last December, which suggests that we are nowhere near equilibrium. Still, the move was received by investors as an indication that we were getting back on track, for both economic growth and inflation.
BACK TO DECEMBER
The Federal Reserve raised rates in December, indicating to the market that it believed both economic growth and inflation were headed toward its targets. And it said as much in its announcement. When the Fed raised the Federal Funds rate in December, it said that “the committee judges that there has been considerable improvement in labor markets this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.” The Fed also said it raised rates “given the economic outlook and, recognizing the time it takes for policy actions to affect future economic outcomes.” This is the Fed’s way of saying that it would like policy moves to take place before inflation and economic growth meet its target so as to stay ahead of an inflation rate that is too high. When we received news from last week’s Federal Reserve Open Market Committee meeting, we heard two things that were important. First, it was not going to raise the Federal Funds rate and second, it is again concerned about “global developments.” Meaning that it is concerned about a further slow-down in global economic growth. Last week, we also received word that the U.S. economy grew by .7% during the fourth quarter of 2015. That is a long way from the Fed’s target. At the same time we learned that the Fed’s measure of inflation, the core Personal Consumption Expenditures deflator was up only .3% for 2015, well below its 2% target. Given the difference between these reports and the Fed’s optimistic statement in December, you wonder -- like the other Taylor (Swift) -- if Janet Yellen is saying “I’d go back to December, turn around and make it all right.” While it is early in 2016, the stock and bond markets have been signaling something inconsistent with the Fed’s more optimistic view. January’s stock market volatility stems from a lack of clarity around corporate earnings, due to fears of slower U.S. and global economic growth. The bond market seems to agree as yields have fallen ever since the Fed’s December move. The two-year Treasury is yielding .83% after peaking near 1.1%. This is a yield that reflects the view of short-term interest rates one year from now and it is falling. Because it has been falling for the last several weeks it may indicate that bond investors don’t believe inflation and economic growth warrant more Fed Funds rate increases this year. In addition, longer-term bond investors also seem to be convinced that interest rates don’t need to rise due to higher inflation and stronger economic growth. After peaking at a yield of 2.5% in July of last year, the 10-year yield has continued to fall. Last week, it hit an intra-day low of 1.92% and is currently 2.0%. Some believe interest rates need to be higher. We believe this is wishful thinking. Rather we need to continue to prepare for a low interest rate environment for a longer period of time. The Taylor Rule suggests that the fair value yield of the 10-year Treasury isn’t too much higher than where it is now. This probably means that unless the economic growth and inflation picture change dramatically, we won’t see much higher interest rates. Still the Federal Reserve’s decision to raise interest rates last December, coupled with its announcement that it anticipates raising rates several times this year, has put it at odds with bond investors and its counterparts in Europe and Japan.
EVERYTHING HAS CHANGED
With the Federal Reserve moving rates higher, we know its policy has changed. However, because the economic fundamentals suggest that we have an economy that can’t grow faster than the 5-year average of 2.1% and a core inflation rate below 1%, we wondered if anything has really changed. And then, Friday’s announcement came. On Friday, the head of Japan’s central bank announced that it was going to introduce a negative interest rate policy for the first time, ever. This is a big change. Especially because the head of Japan’s central bank said just a week earlier that he didn’t think negative rates were warranted. The new policy means it is charging new deposits made by banks .1%, instead of the .1% it is paying for existing deposits. It hopes this encourages banks to lend more which it also hopes will stir economic growth. This led to a 2.8% rally in the Japanese stock market and a better than2% rally in U.S. stocks. In addition to these stock moves, the value of the dollar versus the Japanese yen also rose 2% reflecting the divergence of U.S. and Japanese central bank policy. Stock price appreciation on easier monetary policy moves suggests that stock investors continue to desire central banker support for a slow growing global economy and low inflation rather than focus on the fundamentals of corporate earnings. We’ve noted in past posts, that a stronger dollar isn’t great news for U.S. companies doing business overseas. It makes their goods and services more expensive. While we have a reasonably good outlook for corporate earnings growth this year, one of the things that could derail it, is strength in the U.S. greenback. So why would U.S. stocks rally if a stronger dollar hurts corporate earnings? This is the problem with stock market rallies driven by central bank policy moves. They indicate stock investors are more interested in the easy money policies of central bankers to buoy prices, than they are in improvements in fundamental corporate earnings. Many times in the last five years we have witnessed how an easy central bank policy from the U.S., Europe or Japan can improve stock prices. However, without fundamental improvements the higher prices are fleeting. We continue to believe that corporate earnings fundamentals will be the key driver of prices over the longer term. For now though, it seems that central bankers, and their policy moves will continue to be a main focus for stock and bond investors alike. Similar to how I felt after the fifth song in a row from Taylor Swift, I am ready to hear something new.
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