The Fed's Game with Interest Rates
These days everyone is just obsessed with the what the Fed is doing. Somehow even the mom-and-pops mutual funds and the “value investors” are all up on the Federal Reserve and desperately seeking to interpret phrases just short of a tweet uttered by Janet Yellen in order to figure out when and by how much the Fed will raise interest rates. This is absurd!
Since when has everyone turned into a macro-econ fund manager???? I mean, it makes sense that macro-hedgefunds are concerned with monetary policy since their battlefield lies in currencies and commodities fungibly impacted by what central banks all across the world do. Even a small spike in interst rates changes the entire landscape since the market is already so efficient in the status squo. But why are regular investors concerning themselves with interest rates hikes when they are investing in equities that are only indirectly and marginally affected? One would think equity investors have learned to stop trying to play the market through macro-economic lenses, considering just how horribly the vast majorities of investors have played their theories that lower oil prices would boost earnings in retail…yea, someone needs to start talking about that one of these days.
The point of this post however is to delve into what I suspect is the real strategy behind the Fed. As Robert Shiller’s research points out, although long-term stock market trends are predicatble and consistence with mathematical and statistical expectations, short-term market behavior is very chaotic and often non-sensical. This level of volatility enables macro-hedgefund managers to profit off of currency and commodities shifts that are very small in nature (compared to equities that is), and is directly and empirically tied to just to monetary policy, but to the reactions of the players in the market to their expectations over monetary policy. Yea, it can get pretty weird because the price of currencies and commodities if not just determined by value changes and global economic trends, but also by the positions taken by the players in the market, and those positions are predicated upon theses about the future price of those currencies and commodies, and those theses are themselves predicated upon the reaction these players have in regards to the strategies they expect their competitors to undertake. At some point, this recursive speculation goes to the Fed, because fund managers scrutinize each and every word uttered by the Fed Board in order to understand before everyone else which direction the Fed will take in monetary policy.
A friend of mine once argued that “the President is the most powerful man in the world because he gets to nominate the chairman of the Federal Reserve”, and you can easily see why. I think it was Alan Greenspan that managed to tank the stock market uttering the famous phrase “irrational exuberance”. Starting with Ben Bernanke however, Fed Chairmen (and Chairwomen now ;) ) the Fed has become more concious of its impact on financial markets, and has thus begun to reconsider its role as a major (if not most important) source of news that drives market behavior. In light of this, it is reasonable to consider the Fed’s behavior intentional, for some of the smartest economists in the world has to use all of their tools against the best financiers in the world in the hope to achieve the dual mandate of stable inflation and low unemployement. Essentially, the Fed’s strategy is very much to outsmart fund managers by indirectly forcing them to redirect financial markets towards stability.
It all began with quantitative easing, when the Fed decided to initate huge rounds of asset and bond purchases. The basic idea behind is that by artificially increasing the money supply, investors and businesses weary of inflation will pur their cash into equities. This expectation makes sense for rational investors (and those tend to be the ones with money during a crisis) seek to avoid the losses due to inflation, and equities offer the perfect assets that automatically adjusts for inflation. The second impact of QE is debt deleveraging, for inflation theoretically decreases the real value of static debt, so as more money is given out the more people become able to pay back their debts, which liberates these people to become once again consumers in the economy, which in turn allows companies to profit. Corporations therefore benefit from QE not only becuse investors flood the market, but also because consumers spend more, thus they are able to grow and expand, which means more hiring opportunities and lower unemployement.
QE is thus a perfect example of how the Fed “manipulates” financial markets to promote specific socially useful behavior. Its success is predicated upon the reaction of investors and fund managers to the news of the Fed’s monetary policy, and much in the same way this rate hike ordeal we have been going through these past 2 months is an attempt at the Fed to lead the market into stability. Specifically, the Fed is fully aware that a sharp increase in interest rates, which has to follow QE in order to keep inflation under control, would cause an equities sell-off which would only bring the economy back into the sheds. But how can the Fed get the cake and eat it too??? The trick lies in manipulating fund managers into slowly preparing the market for rate hike, so that when it does happen the shock won’t be severe. Yep, it’s kind of brilliant in its deviousness. By being intentionally unclear about when the rate hike will be, speculators will hedge-themselves, which would in turn get fund managers to slowly divest from equities each month just in the case there was a rate hike. By initiating this process early, the Fed thus gets to “prepare” the market for a rate hike. It’s essentially a play on the law of large numbers, since, in the same way across infinite time a monkey punching random keys on a keyboard will compose Hamlet, by artifically redirecting the economy eventually productivity, the true engine of prosperity and economic growth, will bring the economy back on track.
So yea, I can’t predict exactly when the rate hike will happen and its magnitutde, but I can explain why the Fed is just playing with us. I don’t really care though, because as fascinating as monetary policy and macro-economics is, I am more of an analytical financier anyway. Everyone just needs to calm down, take a chill pill, and start investing free from government pressure.