Is the Fed tightening too much?

Regular readers will know that I have been relatively constructive about stock prices longer term, though I am bracing for further short-term volatility. However, the level of anxiety among my readers is high and I have had to play a game of whack-a-mole with bearish themes (as an example see Why China won’t blow up the world (this year)).

One of the more recent explanations for the current bout of stock market weakness is that the Federal Reserve is engineering an extraordinary level of tightening, as measured by the Shadow Fund Funds rate (SFF). Such Fed action, it is said, is creating a high degree of stress in the financial markets and causing stocks to tank and risk appetites to shrink (annotations are mine).

How concerned should we be about this development?

What is the Shadow Fed Funds rate?

To properly analyze the significance of the SFF, it’s important to understand what it is. I will try to explain the SFF model, but without getting overly geeky.

The basis for the calculation of a SFF rate when Fed interest rate policy originally came from the late Fischer Black. James Bullard, President of the St. Louis Fed, explained it this way in a series of slides. You can derive the option value of holding cash from the yield curve.

You can then calculate the SFF rate by subtracting the option value of holding cash from the nominal Fed Funds rate.

The work by Fischer Black and (later) Leo Krippner of the Reserve Bank of New Zealand on this topic, the calculations to derive SFF was mathematically and numerically difficult because of some of the assumptions involved. It wasn`t under later that Cynthia Wu and Dora Xia came up with a simplified version of the model. More importantly, the output of the Wu-Xia model showed a high level of correlation with actual macro-economic variables as the actual Fed Funds rate. It was a way of validating the Wu-Xia model.

However, I would caution that SFF is a theoretical concept derived from the yield curve. Despite its recent negative values, it is not an actual rate that anyone can transact in. (If you tried to call up the structured products desk at a major brokerage house like Morgan Stanley or Goldman Sachs and asked for a derivative contract based on SFF, they would snicker at you.)

Jim Hamilton, who taught both Wu and Xia, had these comments on the model:

The suggestion is that we then might use the shadow rate series as a way of summarizing what the Fed has been doing with its unconventional policy measures such as large-scale asset purchases and forward guidance. If the Wu-Xia framework is correct, these unconventional policies can all be summarized in terms of what effect they had on the shadow short rate.

In other words, the Wu-Xia rate is a shorthand way of summarizing the Fed`s unconventional monetary policy by observing what was happening to expectations reflected in the yield curve.

Here is THE BIG QUESTION. Is a rising SFF a reflection of tighter Fed policy, or is it a reflection of market expectations of a better growth outlook? The former interpretation is bearish, while the latter is bullish. I would argue that, since the SFF is not an actual rate that you can actually realize and trade on, that it is an indicator of better growth expectations shown in the yield curve.

Are rising negative rates good or bad?

Think about it another way. Ever since the Bank of Japan (BoJ) announced their negative interest rate policy (NIRP), we have seen a lot of hang wringing over the spread of NIRP among global central bankers.

Let’s start with Zero Hedge, who breathlessly reported that NIRP amounted to a failure of QE and central bank policy in the post crisis era:

Over the last week, though, the “central banks to the rescue” narrative has also resurfaced. Not only has the BoJ embraced NIRP policies for the first time, but the ECB has strongly hinted at QE3 in March, and the Fed has added a dovish tinge to its outlook. “Yield”, as a secular theme, continues to stand tall, a full 7yrs after the GFC event. While the growth of negative yielding assets is now well flagged, it’s the other side of the coin which is talked about less: namely the decline in positive yielding opportunities.

And yet, the market’s response to the salvo of central bank action lately has been a shallow bounce. On Friday, the Nikkei’s intra-day performance was up/down/up. And in Europe, our equity team’s “low risk” dividend basket has been lagging behind the jump in negative yielding government debt lately.

The entire world has been watching the European experiment. Four countries in Europe are now at negative rates (see graph below). Two others are so close that it hardly makes a difference. The Federal Reserve and the Bank of England are both at 0.5%.

Switzerland, Denmark, and Sweden all lowered their rates to make their currencies less attractive, since the franc, the krone, and the krona had appreciated too strongly against the faltering euro. Meanwhile, the ECB is trying to stimulate the Eurozone economy and create inflation. The question is, exactly how many unintended consequences will there be with negative rates?

(For the record, to my knowledge none of the banks charge negative rates on required reserves, just on excess reserves. Excess reserves are defined as money on deposit at a bank in excess of whatever the regulators think is necessary to fund the bank’s operations. The concept of excess reserves is a totally artificial one. Aggressive banks will keep reserves as low as possible in order to make maximum returns, and conservative banks will of course hold more reserves. Where do you want to put your money? Then again, if you’re looking to borrow money, which bank do you go to?)

The people that NIRP (negative interest rate policy) hurts the most are those who are living on their savings or trying to grow their retirement accounts, but apparently our all-wise central banks have decided that a little pain for them is worth the potential for growth in the long run. Savers in both Germany and Japan have to buy bonds out past seven years just to see a positive return. Some 29% of European bonds now carry a negative interest rate. Recently we have seen Japanese corporate bonds paying negative interest.

Wait a minute. If negative interest rates amount to a failure of central bankers to re-ignite growth, which is bearish, but a rising Shadow Fed Funds rate (which is a theoretical rate and not an administered actual rate) is bearish….

I’m confused.

The truth is, there is a lot of bearishness out there, as shown by the crowded short of Rydex investors. This sounds like a case of deciding on the conclusion to be bearish first and then manufacturing a reason for the bearishness.

The bears can’t have it both ways. Either a rising SFF is bearish, or it’s a reflection of a better growth outlook and a move away from negative interest rates.

A tactical note on NFP

While we are on the topic of Fed policy, this Friday’s Employment Report will play a critical part in the Fed’s decision on whether to raise rates in March. That’s because most of the key members of the FOMC are believers in the Phillips Curve, which postulates a short-term tradeoff between inflation and unemployment (higher employment = higher inflation). I would highlight this tweet by Urban Carmel, who pointed out that excessively high employment prints, which we saw in the December data, tend to be followed by mean reverting low extremes.

I have no idea how the market might react should we see a headline jobs report of under 100K, but investors and traders should be prepared for that possibility.