Why the Market Gets it, and the Fed Doesn’t

Financial brokers discussing stock market quotes, rear view

This is a strange development. The market and the US Federal Reserve are diverging in their views. The latest Federal Open Market Committee (FOMC) meeting, held overnight, suggests the Fed still intends to gradually raise interest rates this year, while ‘monitoring’ the global economy.

As Bloomberg reports…

‘Federal Reserve officials left interest rates unchanged and said they still expect to raise borrowing costs at a “gradual” pace while watching to see how the global economy and markets impact the U.S. outlook.

‘The Federal Open Market Committee is “closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook,” the central bank said in a statement Wednesday following a two-day meeting in Washington.’

US stocks rallied into the meeting. Clearly, the expectation was the Fed would do what it always does. That is, pander to the market.

But it didn’t. It stuck with the rate rise rhetoric. The market didn’t like it. Stocks began to fall. By the close, the Dow fell 220 points, or more than 1.3%.

What’s going on? Has the Fed abandoned stock market punters? Is the famous ‘Fed put’ (the belief that the Fed will always support the market) a thing of the past?

There are a couple of points to consider.

The first is the Fed’s credibility. It simply cannot turn around one month after raising rates and admit that it was wrong to do so. Institutions like the Fed just can’t do it. There is too much ego and too much arrogance involved.

Instead, it stubbornly stays the course. It thinks, ‘we said we’d raise rates four times this year. We can’t turn around and say we were wrong. Let’s stick with the gradual rate rise narrative for a few more months at least. It won’t look so bad if we backflip down the track. But we can’t do it now.’

The other point is far more worrying. It’s that the Fed doesn’t actually realise what’s going on. The direct quote from the Fed above suggests the main focus is on the ‘labor market and inflation’.

But these two economic variables are lagging indicators. That is, they will be among the last indicators to show that a slowdown is upon the US economy — if indeed that is what is taking place.

If you take note of the market, though, it’s saying a slowdown is here. And you should take note of the market, because it’s one of the best leading economic indicators there is.

That the Fed doesn’t realise this, or at least doesn’t acknowledge it, should be a worry. Because if it continues to tighten monetary policy into a slowdown, it’s making a monumental policy blunder.

It wouldn’t be the first time though. The Fed is always ‘behind the curve’. It took way too long to raise interest rates and now that it has done so, it will take way too long to realise the error of raising them at close to the end of an economic cycle.

The market knows what is going on though. Look at the reaction of gold, for example. Following the Fed’s statement, it jumped nearly US$15 an ounce.

For gold to do this after the Fed stuck with its gradual rate rise rhetoric goes to show the market is losing faith in the US central banks’ ability to manage the situation.

Normally, gold falls on any talk of a rate rise. Indeed, the prospect of rate rises in the US is one of the primary reasons for the ongoing bear market in gold. But the Fed just confirmed a tightening path (albeit with conditions) and the gold price jumped.

You can’t see today’s price jump (to around US$1,125 as I write this) in the chart below. But you can make out the decent rally in the gold price since bottoming in December last year.

Source: StockCharts

Does this mark an inflection point? Does it reflect the market losing faith in the Fed, and a move into gold for protection or as a hedge against owning financial assets?

That could be the case, but you need to see more positive price action from gold before coming to that conclusion. Gold has put in a number of solid bear market rallies over the past few years. But each rally eventually fizzled out, and gold went on to make new lows.

In this case, I’d want to see gold take out the October high of just over US$1,180 an ounce before becoming more positive that the long bear market in gold is over. Let’s see what happens.

One thing supporting gold now is a big increase in uncertainty about the global economy…combined with a lack of confidence in central banks’ ability to manage the situation.

There is an increasing realisation that years of easy money has actually made things worse, not better.

And of course there is China. The ‘she’ll be right’ attitude that has prevailed with China for years is in the process of changing. The authorities might not be as omnipotent as everyone previously thought.

As China’s economy slows, and groans under the weight of excessive (and still growing) debt, the limitations of central planning are starkly apparent.

For example, a leaked document recently showed China’s dilemma. The authorities are now reluctant to ease monetary policy further because such easing exacerbates capital flight and pressure on the yuan.

There are trade-offs in everything, especially economics. In China, the trade-offs are becoming unpalatable. Global markets are aware of it…the Fed isn’t.

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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