Are Fed Mistakes Hurting You?

James Juliano Insights

The Fed dropped the word “patient” suggesting that rate hikes could happen soon, but Janet Yellen also reiterated the Fed’s flexibility and data dependency suggesting that rate hike timing is not set in stone. While many are fretting over the timing of interest rate hikes, we are pleased that the discussion is about when, not if.

Higher interest rates are coming. Do not fear them. Rate hikes, when done for the correct reasons, are signs of a strong economy and are the correct policy action to take. A rising real economic growth rate that pulls up interest rates is an excellent economic scenario for the US economy, jobs and equity markets. The only thing investors should fear is if the Fed completely gets is wrong, as David Malpass suggests could happen. Malpass reminds us how the Fed could make the mistake of not raising rates when they should.

Fed Rate Forecast, Cloudy with a Chance of Slower Growth by David Malpass

How will we know if such a Fed mistake is happening? Two important market “Footprints” will give us clues.

US$ Gold

US$ gold prices should remain stable or drift downwards if the Federal Reserve is correctly matching the supply and demand for US$s with a slight preference for a stronger US$ (lower gold prices). We do not anticipate a large Fed policy error as long as gold remains in or under the $1150-1350 “box” highlighted in the chart below.

Screen Shot 2015-04-07 at 11.11.30 AM2. US Equities

US stocks have been firmly in the “green zone” for several years. Recent market “Footprints” show support around the 1970-2000 level of the S&P500. If large fiscal or monetary policy mistakes begin brewing, we would expect market “Footprints” to begin spending time below those levels. Until that happens, we have little reason to suspect or fear a large policy mistake that would derail the strong US$ equity market.

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Looking under the hood of the US stock market reveals even more strength. The S&P500 is made up of nine sub sectors. In our view not all of those sub sectors are actually US equities. For example, companies in the energy sector are driven much more by commodity prices, especially oil, than anything else. Owning energy sector stocks is really a bet on the commodity asset class even though the vehicle used is an equity. We classify asset classes and sectors by their true economic driver, so energy stocks are commodities not equities. The chart below shows the performance over the last two quarters of all nine sectors in the S&P500. The energy sector has fallen 22% and been a huge drag on overall equity index performance. This is not a surprise, since gold and other commodities have been in a “red zone” since late 2012. The strong dollar, non commodity sectors of the stock market are doing vastly better supporting the case that there is no policy error to fear, yet.

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By the way, that stronger US economy that will drive up interest rates is already here.  As Brian Wesbury points out in his recent analysis of Q4 GDP , “Nothing in today’s report changes our view that the Federal Reserve has plenty of reason to start raising short-term interest rates. Nominal GDP (real growth plus inflation) is up 3.7% from a year ago and up at a 4.1% annual rate in the past two years. For comparison, the average annual growth for nominal GDP is 3.5% in the past ten years and 4.4% in the past twenty years. In other words, we’re not that far from normal growth in nominal GDP, but short-term interest rates remain far below normal.”

Real GDP Growth Q4 by Brian Wesbury

The Federal Reserve is not currently making a monetary policy error, and increasing interest rates in the face of an improving economy would not be a mistake.  This is good news for investment portfolios favoring US$ based asset classes.  Fed policy mistakes are not hurting your portfolio because the Fed isn’t making a mistake, yet.  What is hurting your portfolio is still being invested in inflation hedges like gold bullion as a way to protect against a severe monetary policy error. There are no severe policy mistakes being made at this time.  Watching gold and stocks gives us clues about if and when one is happening.

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