The FED Is Feeding Journalists Stability While Also Confessing Its Cluelessness

April 11, 2017

The FED Is Feeding Journalists Stability While Also Confessing Its Cluelessness

  • Reading the FED’s meeting minutes is necessary to grasp those trends that will shape investment returns but are not explicit or immediate.
  • The FED has started discussing running down its balance sheet if the economy stays on track.
  • However, the FED also just told us that they have no clue what will happen this year or in the next few years. Read this article and the FED’s minutes if you don’t believe it.

Introduction

Last week the FED released its meeting minutes. It’s always a good idea to take a look at the minutes as inside you can find interesting long term trends that aren’t yet recognized by the market but will eventually surface.

One simple example of how minutes can be used to predict longer term trends is the bond prediction I discussed back in May 2016 (article available here). At the time, the FED did let us know that inflation and interest rates were expected to rise but as they didn’t exactly say when it would happen, the market didn’t immediately react. Two months later, the market finally moved and continued to move for the remainder of 2016.


Figure 1: U.S. bond yields rising were an easy long term call thanks to the FED and its meeting minutes (10-year Treasury yield). Source: Yahoo Finance.

Those who correctly anticipated the trend could have made excellent returns or avoided significant losses.

I’ve read the recent minutes, summarized them for you, and added my comments in order to extract the trends that aren’t explicitly stated but will have a significant impact on investing returns.

Main Points Of The FED’s Most Recent Meeting Minutes

Apart from the well-known interest rate increase, participants discussed phasing out reinvestments of treasuries and mortgage backed securities in order to wind down the FED’s balance sheet. Phasing out reinvestments is very important as it will further increase tightening.

Since 2009, the FED has been using two methods to stimulate the economy. The first and most well-known method is keeping interest rates low, while the second method, which provides additional liquidity to the system, is bond purchases.

The FED’s balance sheet has increased more than fivefold since 2009 through purchases of Treasury notes and Mortgage backed securities.


Figure 2: Total FED’s assets in millions of dollars, currently at $4.4 trillion. Source: FRED.

In 2014, the FED stopped purchasing additional securities and now it has started with warnings that it might wind down its balance sheet. However, there is no need to panic as “the reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings.” What’s important is that in the long term, the eventual contraction of the FED’s balance sheet will have a negative effect on bond values. Therefore, if you are in bonds, be careful!

The scenario the FED markets to the masses is the following:

  1. Slow motion tightening will continue if the economic situation stays as it is.

The labor market further strengthened in the first quarter of 2017, the inflation rate is just below 2%, and the economy has continued to grow, albeit on a slower rate than in Q4 2016. These are the main economic factors that the FED uses to assess the economic situation and make policy decisions. As long at the economic indicators stay as they are, the FED will continue with slow interest rate increases and eventually with lowering its balance sheet.

  1. Economic outlook.

The main prediction is that real GDP will expand at a modestly faster pace than potential output in 2017 through 2019. This is good news as it keeps a status quo and allows the FED to tighten its monetary policy in order to reload its guns for the next recession.

A very important factor for all of us is that inflation is projected to slowly increase through 2019 and stabilize in the long term around 2%, but will be allowed to go even higher for shorter periods of time. Inflation above 2% is something significant because it means that in a decade, you will need $121 to buy the same thing you can buy now for $100. Therefore, it’s important to include inflation in the calculations of our investment goals and returns.

In general, the FED’s projections are very stable.


Figure 3: The FED’s projections on GDP, unemployment and inflation up to 2019 and beyond. Source: FED.

The target federal funds rate remains at 3%, and the FED expects to reach that rate by 2019. Such a rate will have a negative effect on all assets as the risk-free rate will be higher and therefore the expected returns from stocks will be higher. Don’t expect positive returns from stocks in the next few years.

This is what everybody expects, however, the chance of the above happening is less than 70%. In order to protect themselves, the committee also disclosed a more variable scenario which is very significant for investors because, as investors, we have to be prepared for every outcome. In the next section, we’ll discuss the variable scenarios that could happen in the next few years.

Possible Scenarios 

The above is what is discussed in the media because the following information is too abstract for the media to grasp. By applying a level of uncertainty and the FED’s usual statistical error from the last 20 years, the picture becomes all but stable.

The FED projects with a 70% confidence interval that GDP growth in 2017 will be between 0.5% and 4%, while the growth interval in 2019 is between less than zero and 4%.


Figure 4: The FED’s GDP projections with a 70% confidence interval. Source: FED.

Now, we can stick our head into the ground and look only at the most certain projections given to the media that are shown in figure 3, or we can prepare for what can statistically happen in the next two years. As I have been around stocks for two crashes now, my choice is the latter. We have to prepare for, well, practically everything.

The unemployment rate will also be somewhere between 2% and 7% in 2019.


Figure 4: Possible unemployment rate with a 70% confidence level. Source: FED.

This simply means that anything can happen and therefore investors should be prepared for everything.

However, until all hell breaks loose, the most probable outcome is that the economy will grow and the FED will slowly tighten its monetary policy. This buys enough time to slowly start preparing for the variegate scenarios described by the FED.

Keep reading Investiv Daily as tomorrow we’ll discuss how to prepare for everything. You might not believe it, but it’s possible to prepare for everything and it can also be very profitable.