The Fed Hits the Brakes

02/26/2019 5:00 am EST

Focus: STRATEGIES

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

The Fed has done a flip-flop. From going their own way a few months ago, they’ve now changed direction, observes market timing experts Mary Anne and Pamela Aden, editors of The Aden Forecast.

This is not uncommon. It’s happened many times before, and it’s happening again.  A while back, for instance, the Fed head, Jerome Powell, said he didn’t think the Fed should be involved in the markets. And once he took over, he continued raising interest rates.

This was a key factor driving the stock market lower at the end of last year, fueling negative comments from President Trump. The pressure mounted and soon Powell began to  change his tune. He took a wait-and-see stance on interest rates and this was an important issue boosting  the market in this new year.

At the latest Fed meeting, they announced they’ll be patient before determining their next step. In other  words, the Fed suggested they may not be raising interest rates any time soon. And they may even lower  interest rates, primarily because of slowing economic signs.

Also important, Powell is now suggesting that the great unwind may start slowing down as well. What do we mean by this? Well, here’s the deal...

During the financial crisis of 2007-08, the world was  in chaos. Remember, this was the worse financial disaster since the Great Depression and it brought the system literally to the brink. The economy was contracting at the fastest pace in 50 years, so the Fed had to take desperate measures.

Not only did they drive interest rates to near zero, but they also started their QE program. This involved buying the govern- ment’s debt (Treasury bonds) and  mortgage debt that other banks didn’t want or need. This was done to contain the crisis and help turn the economy around.

The end result is that the Fed ended up buying $4.5 trillion in debt, adding this to its balance sheet. That’s a ton of debt and it’s still affecting the overall financial world. How?

A delicate act Once the economy started picking up, the Fed eventually ended their QE program and began making efforts to get these bonds off the books. They let maturing bonds expire, and last year their goal was to remove $50 billion per month from their balance sheet — unwinding their balance sheet, so to speak.

As our dear friend and colleague, Chuck Butler notes, every $200 billion that comes off the books is equal to a 1⁄4 point interest rate rise. That means this was happening every four months, in addition to the ongoing rate hikes the Fed was enacting.

So the Fed was tightening monetary policy in two ways — by raising interest rates and unwinding at the same time. The economy began to slow and this spooked Wall Street and Main Street alike. As uncertainty increased, Fed head Powell came under more pressure to cool it.

So, the Fed is now left holding trillions in debt. It’s like a bad hangover that still lingers. But at the same time, the Fed will likely start easing again to help give the economy a boost.

This may all sound great, but it’s really not. The economy’s strength is not built on a solid foundation and it’s vulnerable. As our former Dow Theory colleague Jon Strebler  points out, based on many business cycles, the difference in interest rates should be about 5% between boom and bust times.

Currently, however, the U.S. has a firm economy but interest rates start at 2.25%. Chuck Butler has often noted that this simply does not provide any leeway. It means that if the economy were to slip into a recession, which many are expecting, there wouldn’t be much room for the Fed to maneuver.

Basically, the Fed’s options would then be to buy  more bonds in another round of QE, and to drop interest rates again, possibly to below zero. These would  pretty much be the only tools the Fed would have to stem a recession and boost the economy.

Meanwhile, interest rates are mixed. The major trend is up for short-term interest rates, like the Libor rate, Fed Funds and T-Bills. It’s also up for the 30-year yield, as long as it stays near 3%. The 10-year yield, however, is declining and if it stays below 2.83%, the major trend is down.

As for bond prices, they’re neutral and still vulnerable. We continue to feel it’s best to stay on the sidelines for the time being until we see how this balancing act unfolds.

Subscribe to The Aden Forecast here…

Related Articles on STRATEGIES