BUNK 28
DON’T FIGHT THE FED
The saying “don’t fight the Fed” is the popular (and misguided) notion “everyone knows” that a few consecutive Fed rate hikes are bearish, whereas falling rates are bullish. The idea is loose monetary policy leads to lots of extra liquidity and is good for stocks—but tightening sucks money from the economy and is bad for stocks. Some folks think “don’t fight the Fed” applies to the discount rate, others to the fed funds target rate, still others to short-term rates in general. All wrong!
Instead of “don’t fight the Fed,” I wish everyone knew that any market adage that says, “Always sell on this one condition, buy on that one,” is wing-nut time. (If only investing were that easy!) There is, to my knowledge, no one single indicator that works consistently and is failsafe. And if you just know that no one indicator is close to failsafe, you know this adage is bunk.

A Monetary Phenomenon

But suppose you want evidence. Consider recent history. From 2001 to 2003, the Fed steadily cut rates—while stocks tanked. If you had been obediently not fighting the Fed, you would have been nailed by a big bear market. The same was true, but worse, in the 2007 to 2009 bear market. The Fed dropped rates starting late in 2007—just as the bear market began—all the way until the target fed funds rate was down to 0 to 0.25 percent. And that was during a major bear market. Conversely, the Fed raised rates from 2004 through 2006, during a bull market.
What gives? It’s true, dropping rates is one way the Fed can increase money supply. But do they do it drastically when the economy is cooking along? Not if they have their heads screwed on straight. Remember what Milton Friedman said about inflation being “always and everywhere” a monetary phenomenon. Dropping rates a bunch when the economy is zipping is like pouring fuel on a fire—it could cause runaway inflation. The Fed, if behaving appropriately, starts raising rates not because the economy is troubled, but because they think it’s necessary and, more importantly, the economy can handle it. This is almost the exact opposite of what the “don’t fighters” are thinking. They presume somehow the Fed is usually wrong. Sometimes it is. Usually it isn’t. Usually when they raise rates, the economy and markets can take it.
Truth is, stocks can rise and fall on rising or falling interest rates. While the Fed is being overall accommodative, they might raise or lower rates within a range. The same when they’re overall a bit tighter. A move up or down of 25, 50, even 100 basis points might, in the large scheme of things, not be a big deal. Would you buy or sell every time the Fed makes a policy wiggle? And it’s true—a lot of liquidity sloshing around globally often does find its way into stocks, and that can be positive. But the fed funds rate isn’t the only thing impacting global liquidity. America’s economy is just 24.6 percent of world GDP1—central bank policy elsewhere matters, too.

Exit Jitters

In 2010 as I write, on the tail-end of a historic, massive wave of global monetary stimulus (i.e., falling rates globally combined with quantitative easing all while stocks fell in 2008 into early 2009), there’s huge fear of a “too-early” stimulus exit. (Of course, there are simultaneous fears the exit will be too late. Sometimes you can’t win.) What folks fear isn’t a little rate wiggle in a bandwidth. They fear a total trend reversal—the start of a legitimate tightening cycle—that central banks raising rates will choke off recovery. The world’s gone “don’t fight the Fed” crazy.
But a check of history (debunkery!) shows there’s little precedent to worry about the start of a tightening cycle. Table 28.1 shows US stock performance following the first rate hike in a sustained tightening cycle. Not always but overwhelmingly, stock returns are positive 12, 24, even 36 months later. There’s nothing that says starting a tightening cycle must spell doom.
Table 28.1 S&P 500 Returns Following the First Rate Hike—Don’t Fear a Fed Hike
Source: Thomson Reuters, S&P 500 price return.
028
Table 28.2 MSCI World Returns Following the First Rate Hike—Don’t Fear a Fed Hike
Source: Thomson Reuters, MSCI, Inc.,2 MSCI World price return. Returns before 1980 use end-of-month values.
029
But because US and non-US stocks are typically strongly correlated, this one works pretty darn well for world stocks too (see Table 28.2). Following Fed rate hikes, world stocks have largely been fine 12, 24, and 36 months later. Nothing to fear here.
Generally, it makes sense that a sustained tightening cycle begins after a recession is widely apparent. While the Fed certainly makes mistakes, they generally don’t want to tighten too soon in an economic recovery. After all, Fed heads are inherently political creatures—they’re appointed! They like their jobs and want to keep them—they don’t want to botch a recovery, which makes their boss (i.e., the president) look bad. He’s the guy who reappoints them.
Tables 28.1 and 28.2 also tell you that, generally, stocks tend to rise for long periods—longer than most think. And they tell you an initial rate hike, or even a tightening cycle, is, by itself, little to fear.
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