Tuesday, August 5, 2014

Before Moving to Cash-READ THIS!

Dire warnings of forthcoming equity weakness have been accumulating.  We read this morning in Zero Hedge, ‘Deutsche Bank "Raises The Warning Flag": What The Most Important Chart For The Market Reveals’ , that Deutsche is latest to throw into the notion that a strong correction in equities as imminent. 


The Deutsche Bank note mentioned and quoted in the Zero Hedge article states’ As you can see, since the Fed balance sheet was used as an aggressive policy tool post-GFC, the graph suggests that the S&P 500 is well correlated with the size of the Fed balance sheet with the former leading the latter by 3 months.’  The Deutsche Bank team under Jim Reid has found a rather compelling visual ‘fit’ for Fed Balance Sheet/S&P 500 overlay.  However, it is important to recognize that the inference made is not statistically strong.  There really is only scant reference data available for a projection to be made with any confidence. 


It is easy to make the connection between Fed security purchases and the prospects for equities and therefore - many do.  It is intuitive, compelling and easily understood and therefore we are drawn to make conclusions based on this simple logic.  However, in doing so we risk making compelling conclusions without giving enough consideration to other important variables.


One such variable is the Fed’s guidance.  We might build a similar overlay to demonstrate that as economic agents became more confident in their understanding of Fed policy intent over the upcoming months (years), risk assets (S&P 500 as proxy) appreciated. The Fed has come a long way toward recognizing the importance of communication in the application of Fed policy.  Fed Chair Yellen has come to consider Fed Guidance as a policy tool in itself. 


Today, the clarity of Fed policy intent is less crystal clear.  Because of some variance in the progress of economic growth over the last 6 months, demonstrated more dramatically in recent economic releases (Q2-GDP and July Employment Report), confidence held by economic agents concerning their projections of Fed policy intent has declined.  The decreased confidence of economic agents in forecasting Fed policy intent may have had a STRONG influence on the reaction in risk assets.  The Fed’s policy rate was more widely expected to find a lift-off from zero interest rate policy (ZIRP) in mid to late 2015.  The stronger than expected showing of Q2 GDP has some bringing forward the lift-off date while the most recent employment report has had the opposite effect. 


Additional guidance provided by the Fed in the form of the status of their balance sheet portfolio of securities has been helpful in supporting more confidence by economic agents in their understanding of overall policy intent.  Specifically, the Fed has provided economic agents a strong understanding for the ‘policy-path’(‘the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings’) of tapering as initially outlined in the December ’13 FOMC statement.  A very strong majority still expect the Fed to complete its asset purchases ‘on schedule’ in October.  The understanding of policy intent with regard to tapering as well as indications of likely (if vague) time interval between purchase program end and lift off date for the policy rate have offered economic agents considerable visibility and therefore confidence in holding risk assets.  Additional, if also somewhat vague, further support (through added visibility) has been provided by the stated intent from the Fed to hold the portfolio for a long time.    


Although the current portfolio guidance about tapering is supportive, its life is coming to an end.  In October, the purchase program will come to an end.  The value or ‘visibility’ provided by the understanding of Fed policy intent with regard to the tapering of asset purchases has been like a waning asset.  It provided its strongest potential support upon announcement in December and has offered successively less visibility as FOMC meeting dates (discrete policy-path value dates) have passed. There is little support left in the known policy path for tapering.  The Fed is currently absent enough policy intent guidance to support risk assets.


The Fed over the coming months and FOMC meetings will want to replenish the amount of policy intent guidance that it provides.  We might expect some guidance updates in the form of intended policy tool usage in forthcoming efforts to remove excessive accommodation.  In this the Fed could outline more formally the intended usage of interest on excess reserves (IOER), overnight reverse repos (ON RRP) and term deposits as well as the role for fed funds in ‘normalizing’ monetary policy. 


As described recently the uncertainty about Fed policy intent has increased and therefore the risk for greater volatility has grown following the dissent by Philadelphia Fed President Plosser at the latest FOMC meeting.   Mr. Plosser opposed the ‘Statement’ use of ‘considerable time’ in describing the appropriateness for maintaining current policy rate target range, arguing; ‘because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee's goals’.   His concern for the ‘time dependent’ nature of the ‘considerable time’ portion of the statement gives rise to greater uncertainty concerning policy intent.  This dissent raises questions for the lasting nature for this guidance measure.    


The message here is that while the level of securities holding by the Fed may have some impact on the valuation of equities, the guidance the Fed offers about policy intent may be even more important in promoting confidence economic agents afford their own forecasts.  It is the levels of confidence economic agents have in their forecasts, not necessary a similarity of views that builds support for economic growth.  Risk assets have shown an ability to thrive in the past during removal of accommodation.  Specifically, note the dramatic rise in risk assets during the removal of accommodation through the ’04-’06 ‘measured pace’ guidance.


We might expect that while uncertainty in Fed policy intent remains high, the volatility of asset markets will remain higher than usual.  At some point however, greater confidence will be attended forecasts for Fed policy intent.  At that stage, even should the monetary policy path be expected to become less accommodative, there will be room for volatility to decrease and risk assets to be once again sought after…at a price.  Depending on the level of visibility provided by Fed transparency, economic agents will become appropriately confident in their understanding for the hurdle rate for all measures of risk assets and economic enterprise.


Economic agents therefore wait impatiently for the next measure of Fed Guidance.    

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