Debunking the Fed Myth of Three Steps and a Stumble

Last week, Federal Reserve Chair Janet Yellen hinted that a March rate hike is on the table. If the Fed indeed raises the federal funds rate by 25 basis points on March 15, the hoist will be the third time in a row. The market tranquilly reacted to the news last Friday, but drifted low on Monday and Tuesday, with each major index down less than 1%. However, behind the calmness of the market is the quirk of the Dow Jones Index back and forth countless times intraday on Friday around the “Maginot line”— 21000, telegraphing the ambivalence among investors.

Just two weeks ago, the federal funds futures indicated less than a 30% chance of March hike. Should the investors worry about the Fed’s March move? Not necessarily!

In fact, given that the equity indexes have more than doubled during the past eight years, the huge wealth effect from index advancement will improve the economy in the months ahead. But the Federal Reserve seems to be anchored on the last great recession, while slowly raising interest rates.

Over the past 100 years, the Federal Reserve has battled far more recessions than inflations: the 1930’s Great Depression, internet bubbles, great recession; high inflation struggle in the 1970s, which was far less severe than 1920’s Germany’s hyperinflation when one truck of Marks could buy only one loaf of bread. The Federal Reserve’s anchoring on recessions appears to be what Ludwig Erhard, West Germany’s minister of economics in 1958 explained to President Eisenhower: “Whereas Germany, because of their history, always worried about inflation, the Americans, because of their history, always worried about depression. The resulting danger was that America would overreact to threats of recession and cause serious inflation in the long run.” The reality of 1970s inflation can be shown to be very far from Ludwig’s rhetoric.

The change in the Fed’s tone over the last week is partially reflected in the recently humming market, forcing the Fed’s prompt talk before action. Without the hawkish comments from Fed officials, the interest rate hike in March may send the market into a tailspin. In terms of Rigobon and Sack’s research*, an unanticipated 25-basis point increase in interest rate may result in a 1.7% decline in the S&P index, 1.2% drop in Dow Jones Index, and 2.3% plunge in NASDAQ Index. This may trigger another 13% market correction after the first federal funds rate hike in December 2015 when the Fed had not communicated well with the market. The Fed under Yellen knows this, and of course will not want to create similar market turmoil.

So, at a speech before the Executive Club of Chicago on March 3, Chair Yellen discussed the US economy and the Fed’s monetary policy. She explained that the Fed’s ultimate goal of interest rate lift is the longer-run value of the neutral real federal funds rate (NRFFR) to be in the neighborhood of 1%. The neutral “real” federal funds rates, defined as the federal funds rate adjusted for inflation, is neither expansionary nor contractionary when the economy is running near its potential. She expected NRFFR to rise until 2018 and 2019. Although the NRFFR is essentially a moving target dependent on inflation, Yellen forecasted inflation will be around 2% over the medium term. This implies a 3% target for the federal funds rate ahead.

If inflation rises to 3%, the target for the federal funds rate would be 4%. When the economy overheats, inflation may rise fast. The Fed would theoretically raise the federal funds rate even faster, according to the Taylor Principle which says that an increase in inflation by one percentage point should prompt the central bank to raise the nominal interest rate by more than one percentage point.

Now, investors may ask: Will the rise in rates kill the bull market? And if not, when will the bull run end, or when will a big correction happen?

There are no “sure” answers to these questions. However, an old market myth created by Edison Gould says “three steps and a stumble”. The “ Three Steps and A Stumble” rule states that when the Fed increases one of three monetary variables (discount rate, reserve requirement, and margin requirement—changed to open market operations due to its efficiency), the stock market will stumble. Here, we focus on discount rate variable to find out how the third jump in interest rate had impacted previous four bull markets—the Soaring Twenties ( 1921-1929); Construction Years(1950-1959); New Paradigm (1990-1999), New Millennium (2003-2007).

Market analyst Norman Fosback found the Fed raised interest rates a third time on July 13, 1928. Fourteen months later, the S&P 500 peaked on September 7, 1929, then dropped 82%. On September 9, 1955, the Fed lifted interest rate third time. Eleven months later, on August 2, 1956, the S&P 500 topped, starting a 21% market correction.

During the New Paradigm 1990-199 period, the Fed engaged in two rounds of interest rate hiking cycles in the latter first half and second half. After the interest rate bottomed out at 3% on September 4, 1992, from the high of 8.2% in early 1990, the Fed became hawkish, cautiously lifting rates by 25 points on February 4,1994. On that day, the S&P 500 plunged 2.27%. Two months later, on April 18,1994, even though the S&P 500 had declined 10% since the first rate raise, the Fed hauled up rate again by another 25 basis points, with the S&P 500 falling 0.83% that day. However, the market sank further, with another four 25 basis point raises by the Fed. Nonetheless, this round of hike cycles soothed the market froth by causing a one-year market correction. The correction led the third interest rate raise by over two months.

After over four years of the Fed’s indecisive monetary policies due to Asian currency crises, LTCM Failure and Russia debt chaos, the Fed again initiated hiking interest rates by 25 basis points on June 30, 1999. The stock market cheered with Fed action, with the S&P 500 advancing 1.6% that day. Because the market kept heating up, the Fed was forced to raise the rate a third time, by another 25 basis points on November 16, 1999. Unfortunately, the market defied the Fed and the S&P 500 moved up 1.8%. The S&P 500 peaked at 1553 on April 18, 2000 after four months of the third rate raise ^{Table 1}.

From the third rate lift on March 22, 1994 to the market peak on March 24, 2000, the market zig-zag advanced nearly 72 months ^{Table 1}.

After the internet bubble burst, the Fed dropped interest rates to the lowest 1% on June 25, 2003. One year later, the Fed saw a bright sign of economic recovery, raising interest rates the first time on June 30, 2004 after a previous thirteen instances of interest rate easing. The S&P 500 moved up 0.4% that day. On September 21,2004, the Fed hitched up the rate a third time, but the market continued its ascendant journey. The S&P 500 peaked on October 11, 2007 after 35 months from the third interest rate hikes for total snail pace of seventeen 25 basis point lifts, and then cracked over 57% ^{Table 1}.

From the above analysis, we can roughly guess how the market will move after a third interest rate hike next week, March 15.

1. If the market starts stumbling around the third move, the downside could be limited, paralleling to 1990s’ tightening cycle; 2. It could take 30 months after March 15 for the market to arrive at its final summit; 3. Each hike may be 25 basis points for the foreseeable future; 4. The peak federal funds rate could be around 4%.

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This is just a personal opinion, and personal opinion is often wrong. Currently, the author has no position on any of the above mentioned stocks, and may or may not build any position on any stocks above in the future.

Notes:

• Roberto Rogobon and Brain Sack: The Impact of Monetary Policy on Asset Prices. NBER, January 7, 2004.

Table 1: The Federal Fund Rates Change Dates 1990-2008