Investors vs. the Federal Reserve
Today in the United States of America, we are stuck in an economic paradox. The Federal Reserve has kept a policy of emergency stimulus for nearly a decade. The question becomes, how much does our economy rely on the easy money policies of the Federal Reserve, and what are the driving factors behind the decision to normalize rates(to end the emergency stimulus).
To speculate as to why normalizing rates today has become a constant talking point anytime economic news is released. Low rates (near zero) have contributed to the entire interest rate curve to fall and flatten to levels never seen before. The effects of the lower yield curve have enabled homeowners and businesses to borrow capital at extraordinarily low rates. This has also extended to the US government, with nearly ten trillion dollars being added to our national debt within the last decade.
The one particular party I would like to focus on today is the investor(both institutional and retail). We generalize the investor I will assume that the majority of their assets are invested across the entire stock market either through passive mutual funds or market ETFs. This principle of diversification is widely accepted in the field of investing and finance. Therefore we arrive at the two parties we will analyze against each other, the market and the Federal Reserve, looking at what might be the leading factors behind the decision to raise rates or not to. To generalize this further, since the market cannot raise rates, we define their decision variable to be to price in a rate hike, or not to.
Game Theory matrix of Investors vs. the Federal Reserve
The interesting fact that lead to this analysis is the Market is playing a dangerous game. The US stock market will usually choose to price in a no rate increase, regardless of what it thinks the Federal Reserve will do. This seemingly reckless decision forces the Federal Reserve to be reactionary to the markets and thus keeps rates at near-zero levels. Why might the stock market due this, because if you had been invested in the stock market and the Fed choose not to raise rates, the market tends to increase. This interesting correlation is explained by an article from the Economist called “The long arm of the Fed.” Interestingly if you invested in the stock market only on weeks of a FOMC meeting, you actually greatly outperform the market. This correlation has existed since 1994, but the returns as of recently have been much greater due to the yield curve being extraordinarily flat. The results of the study have concluded:
“But the study analyses a remarkable correlation. Usually every fortnight between FOMC meetings, fresh information is discussed in a gathering of Fed governors. It finds that all the gains in the stock market have occurred, on average, in the weeks of the FOMC meetings and the ones that involve the governors alone. A dollar invested only during those weeks would have grown more than 12-fold over the period. A dollar invested during other weeks would have lost half its value.”
This remarkable correlation is due if rates continue to stay low, stock market valuations will increase due to how low rates affect financial valuation models such as the discounted cash flow analysis. Lower rates also allow companies to invest in lower yielding projects due to the low cost of financing projects, thus expanding business growth and returning a larger net income to investors. This perceived growth and increase in valuation is almost single handedly due to the effects of low rates. When the Federal Reserve decides to keep rates near-zero, the market reacts positively to this news as the longer the Fed makes this decision the flatter the yield curve becomes. The lower cost of long-term bonds have the stated affect on businesses mentioned above, which investors treat as positive. Thus we have seen an outperformance in the markets during FOMC meeting weeks.
For investors, it is a simple game. Keep rates low or decreasing and businesses will grow and their respective capital structures will improve. This leads to better corporate profits which increase the bottom line, and ultimately are returned to the investors. It’s an old fashion game of who has the dominant strategy, if the Federal Reserve took a Hawkish position on rates the market would be forced to price in a rate increase, but they have been resoundingly Dovish since the crisis. Investors have since taken full advantage of the newly Dovish Federal Reserve and today our stock markets are trading at or around all time highs.
Article referenced: http://www.economist.com/news/finance-and-economics/21706278-central-bank-may-exert-strange-sway-over-stockmarket-returns-long-arm