“Every great magic trick consists of three parts or acts. The first part is called “The Pledge”. The magician shows you something ordinary: a deck of cards, a bird or a man. He shows you this object. Perhaps he asks you to inspect it to see if it is indeed real, unaltered, normal. But of course, it probably isn’t. The second act is called “The Turn.”
The magician takes the ordinary something and makes it do something extraordinary. No one is looking for the secret, but one will not find it because of course, one is not looking. One does not want to know. One wants to be fooled. But one would not clap yet. Because making something disappear is not enough – one has to bring it back. That is why every magic trick has a third act, the hardest part, the part one calls “The Prestige”.” —- John Cutter, ‘The Prestige.’
Setting The Stage: Sentinel Or Illusionist?
Trying to predict the actions of the Fed is an exercise in futility for value-oriented investors.
Throughout 2016, the question of a possible Fed rate hike flooded the media. Last week’s meeting signalled that a hike is imminent by the end of the year. However, should one waste precious time and energy debating the timing and extent of this probable event? Fight the Fed, do not fight the Fed – this is a constant debate that comes at the expense of academic discussions about the real issues that matter.
On this note, it is the right time to explore a dangerous misconception about the relevance of the Fed.
The ignorance lies in the belief that the Fed conducts the functioning of the financial markets through their command of long-term interest rates – a statement of two parts, both of which are false. The Fed does not control the markets, and it has no direct control over the movements of long-term rates.
Thanks to a few sage and respected investors who have shared their wisdom, these truths are slowly becoming ubiquitous. The broader market is learning about the actual relevance of the Fed, the anatomy of macroeconomics and how both are practically linked by the behaviour of contracts and its participants. The result of which may hopefully be a more cautious optimism and scepticism as to the real risks to global markets.
To understand how the Fed is associated with rate movements, some macroeconomic mechanics must be understood.
Just as interest rates affect inflation, the expectation of inflation affects interest rates. And because one of the Fed’s principal purposes is to monitor inflation in the US, people tend to think that they must also have control over interest rates. This is a fallacy. Interest cannot be created or set by a single entity. Interest rates are set ex-post by members of the real economy (banks, other businesses, investor sentiment and expectations, etc.), who act on behalf of expected economic growth in the economy and expected inflation.
The Fed’s only lever of decision making in the real economy is the setting of the target Fed Funds Rate. This range of a target rate is direct at banks, whose decisions directly affect the markets and the real economy as they are the foremost providers of credit. Nevertheless, this only has a significant impact on short-term interest rates, which shows how inadequate this effect is for investors with a long-term horizon.
The only influence that the Fed has over long-term rates is the fact that their policy and commentaries on the economy send signals that may dictate the actions of market participants due to the credibility that the Fed holds in the global marketplace. Interest rates movements may or may not run in the course of the Fed’s policy. Therefore, the setting of interest rates is a blend between market forces and Fed intervention. This understanding is of paramount importance for intelligent investing.
People place too much value on the Fed’s views/evaluation of the economy. They should be one of many sources of information, not the Dalai Lama. People believe that the pedigree that fills the walls of the Federal Reserve banks equate to superior analytical minds and magical foresight. They have faith in the integrity and rigour of the Fed. But, what happens if even one of these premises is faulty from the start?
Nonetheless, it is important to explore the tools at the disposal of the Fed that can manipulate interest rates. The two main ones are the following:
- The first one refers to the Fed Funds Rate, an interbank rate at which banks and other depository institutions lend/borrow funds that they hold at the Federal Reserve to each other overnight (short-term). The setting of a target for this rate sends a signal about the Fed’s view of the economy.
- For example, if the Fed raises the Fed Funds Rate, the indication sent to the market is that the Fed thinks that the economy is strong and possibly overdue in its expansion. A high rate affects the banks’ reserves, and would discourage them from lending to each other as it becomes more expensive to do so. This could consequently affect business activity given that companies might dispense borrowing as they would have to pay higher interest on their loans. This would slow down the economy and push down inflation. Investors then end up resetting expectations and adapting.
- The second way in which the Fed indirectly affects interest rates is through the purchase or sale of government bonds. This activity has two important effects that in turn, affect interest rates: (a) the amount of money held by banks in their reserves and (b) the supply/demand dynamics of the bond market. Exploring the example of quantitative easing, whereby a central bank, for example, the Fed, purchases government securities to increase the supply of money and promote economic growth when the economy stalls:
- The money spent by the central bank in the purchase of those government securities would be credited to the reserve accounts of banks, which means that the banks would have more money to lend and thus be more willing to do so. The effect of this on business activity and consumption are lower interest rates as the reserves of banks would increase, and they have less need to borrow money from one another, instead of using their money to invest in riskier assets. This, in turn, affects businesses and consumers who are encouraged to stop saving and start investing and spending.
- When the Fed buys a security, it does so from an investor (banks, institutions, etc.), who will then use that money to invest in something else. The idea is that by lowering the supply of bonds through purchasing, and simultaneously increasing the demand for them (accounting for the credibility that the market places up the Fed’s decision-making ability and its intellectual capital), the prices of those bonds go up which in turn lowers their yields, causing investors to move towards other, riskier assets. In turn, the return of those assets drops as their ownership becomes crowded. The increased liquidity refers to the increase in the supply of money in the market, which brings down the price of money (interest rates). The opportunity cost of holding cash versus investing in other assets gets too high, which lowers the interest of borrowing in an effort to stimulate investors and businesses to do so at a low cost.
It is critical to understand exactly why people have faith in the hegemony of the Fed over global markets.
People’s belief in an “all-powerful Fed” is a function of hardwired psychological tendencies. Humans get overwhelmed by the continuous stream of chaotic and contradicting information all around. As a result, either people get too lazy to try to understand the stream of data or they fail to do so successfully due to probably the gravest issues: myopia. The failure to distinguish the forest from the trees at times impedes one to connect the dots and thus achieve a clear understanding. Therefore, the market decides to embrace a false sense of understanding and control over the functioning of the global economic machine.
So the closer one looks, the less one sees.
Understanding this chain of reasoning helps investors guard against inevitable and intuitive decision-making.
There seem to be two schools of thought in regards to responding to the Fed as an investor:
- “Go with the Fed” – follow the Fed’s views and profit from price momentum and trend creation. The issue with this is timing, which is a whole problem on its own, worthy of not only another blog post entirely, but of a book.
- “Fight the Fed” – forget about whether what the Fed is opening and specifically stating represents the reality of markets, and instead, focus on (1) what people believe, and consequently (2) how they will react to information based on those foundational beliefs, and finally (3) what this says about present prices and where it will lead them in the next couple of years.
While both approaches (a shorter-term trading strategy versus a longer-term investment one) are worthy, one must make a choice.
John Burbank of Passport Capital exposed and challenged the consensus view of the role of the Fed as the “sentinel of the market,” stating, in a recent interview with RealVision TV, that the Fed has been acting as a magician, a professional whose purpose is the diversion of attention to promote surprise and entertainment. Burbank argues that the Fed has been directing people’s attention towards the question of if and when a hike is coming, away from the serious global issues.
However, unlike the audience at a large-scale magic show, investors are not fond of such surprises.
What matters most then? The most serious issues are the insane and intoxicating debt levels, lack of productivity growth, and the deterioration of liquidity in the markets.
So how does all this apply to the on-going debate of a Fed rate hike and the possible event itself in December?
By acknowledging that people think (1) that the Fed sets interest rates, and (2) that asset prices have been up because of such low rates, which are two fallacious premises, investors can prepare and profit from short-term price dislocations of assets that have not seen any change in their underlying fundamentals.
Use perception to buy cheaper. Do not follow it for investment signals. Focus instead on the real big picture changes in the global economic sphere and the markets. And play these themes by buying high-quality businesses (primarily, but not exclusively, in the US) with high liquidity and great management with a proven track record of opportunistic capital allocation, which will be the testing variable in the upcoming years of low expected growth.