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Sunday, January 10, 2016

Why The Fed Should Ignore The Stock Market

Chart: S&P 500

The headlines are blaring that the stock market has had the worst start to a year since practically forever, and the "Markets in Turmoil" specials are filling the airwaves. It is entirely possible that the sell-off reflects underlying risks to the global economy, but as I argue here, whatever is happening in the stock market is not adding any new information. In particular, the best course of action of the Fed is to ignore the panic, and the same holds for fixed income investors and macro-economists.

Reasons To Panic

The arguments to be deeply concerned about the U.S. economy are straightforward.
  • The global commodity sector is in recession, particularly the energy sector. Oil is back with in the $30 range, which is painful for us believers in Peak Oil (ouch!). If you have a business in Fort McMurray, you should panic (that is, more than you already are). The North American unconventional oil business was in a major expansion earlier this decade, and that expansion is reversing.
  • Commodity extraction uses a lot of heavy industrial equipment. Investment cuts will be felt by a global supply chain of capital goods producers, many of which are located far away from coal faces and oil rigs.
  • Commodity producers will be cutting back their free-spending ways, causing a ripple effect on consumer goods producers globally.
  • It looks like we are due for some high yield bond defaults, which tends to have a chilling effect on financing in that market.
  • Investors had been increasingly desperate to hit return targets, which led to investing and lending standards being stretched. This exuberance could reverse as investment projects fail.
  • The United States economy was barely growing in the first place, with the employment-to-population ratio largely stagnant. 

Why The Fed Should Not Care

  • It is too late to do anything about a global recession. If it happens, a move in the Fed Funds rate 25 basis points in one direction or another is irrelevant.
  • Nobody in their right mind treated high yield bonds as being "money good" in the first place. If the high yield market cracks, the losses will be absorbed by investor portfolios that are designed to absorb valuation volatility. Conversely, during the Financial Crisis, dubious loans were converted into "money" via securitisations, which drew into question private sector "money" in general.
  • It is unclear that weakness in the commodity sector is enough to overwhelm the automatic stabilisers within the U.S. economy. (The latest Employment Situation report shows that the job market is still moving forward at a slow pace.)
  • Much of the commodity carnage is emanating from a withdrawal of Chinese demand. The Chinese stock market is essentially a casino, and so we should not be surprised by anything it does. As for the trajectory of the economy, it is still a Communist country where the central planners have considerable scope to keep the quantity of activity moving (although one can debate the quality of activity). The stagnation of earlier "Asian Miracle" economies had only limited direct impact on developed economies. U.S. firms that were in direct competition with Asian suppliers were put out of business decades ago.
  • Falling stock prices excite people who own shares, but they are easily reversed. (One can eyeball the stock price chart at the beginning of the article to see lots of similar squiggles.) A financial crisis is only a crisis if there are serious defaults, which are irreversible events.
  • A recession requires that firms get rid of excess employees. If they have not been hiring, there is no excess to be fired.
However, the Fed has boxed itself in. Current projections imply rate hikes of about 100 basis points a year, which corresponds to a 25 basis point hike every second meeting. They could skip the next meeting, and be consistent with this path. Unfortunately, they did not announce a strategy of hiking every second meeting, and so if they skip the upcoming meeting, people will interpret this as the Fed panicking. 

Once again, the Fed should have not listened to the academics that told them that transparency was good; if they kept their mouths shut, nobody would be in a position to care about 0.25% movements of interest rates.

Should Bond Investors Panic?

The bond market should follow their expectations for the Fed, and also ignore the latest news flow out of risk markets (beyond the credit markets). If you think the shock to the commodity sector is big enough to drive the economy into recession, you should have already positioned yourself for lower interest rates a few months ago. If you don't think it is enough, you probably should be thinking that bond yields will be stuck in a trading range, and the lower end of that range will be reached sooner or later.

As for my view, I do not have enough information to make a recession call. Regular readers will have realised that I have a "glass half empty" world view, and that I do not see any fundamental reason for a rate hike. However, I have enough faith in the "automatic stabilisers" within the economy that I see the current events just being another wiggle in the trajectory of sloppy growth that we have experienced since the end of the recession. The situation for other countries is more complicated; it depends how exposed they are to the global commodity recession.

Whither The Yield Curve?

Chart: 2-/10-year U.S. Treasury Slope

Finally, I have run across a fair amount of discussion regarding the message of the "yield curve" -- for example, the slope between the 2-year and 10-year Treasury. I doubt that there is a message.
  • The flattening of the curve reflects the fact that rate hikes cause short-term rates to rise more than long-term rates. Long-term yields already reflected an eventual renormalisation. The fact that the curve is much flatter than was the case earlier this cycle (for example, in 2010) just tells us that bond investors had unrealistic expectations about the pace of policy rate renormalisation.
  • On the other hand, we should not expect the yield curve to invert (negative slope). There are large institutional barriers against negative bond yields, and so the curve will not invert so long as the policy rate is still close to zero. Therefore, we will not see the usual pattern of an inverted yield curve ahead of a recession (which has been one of the most accurate recession indicators historically).
(c) Brian Romanchuk 2015


  1. One has to be very careful when looking at the non-farm payroll figures.

    Headline numbers and seasonal adjustments can significantly distort the data.

    In the case of the December figures, excluding the seasonal adjustment, the economy has only created 11,000 jobs (, table B-1) in a much milder weather environment than previous years. This could suggest that the 292,000 seasonally adjusted number is inflated (starting from a weather-inflated based).

    One should also look at the number of multiple jobholders (table A-9). When looking at non-seasonally adjusted data, 259,000 workers had to get second jobs, which suggests that the workers are not getting proper wages and need to resort to second jobs to make ends meet. How can a customer spending driven economy go on like this?

    Lastly, the pace of new jobs in certain low-paying categories (such as retail trade, temp help services, education and health services, leisure and hospitality; Table B-8) suggests that the US economy is created unsustainable new jobs (low wages bartenders will spend their money at other bars?)

    1. Hello,

      I dislike the Payrolls data; instead I follow the Household data, where the number of jobs is inferred from the employment to population ratio. It's noisy, especially if you look at the number of jobs, but the underlying trends are stable (and do not have the systematic bias of the Payrolls number). The employment-to-population ratio rose again, which is consistent with no slowdown in the U.S. - yet.

      I agree that the quality of job creation is weak, and so we are far away from an overheating job market. That said, I have a bearish bent, and realize that I should not wallow in confirmation bias. I try to avoid explaining away the trend in data, unless I know that there is something seriously wrong with it. (For example, how the fall in the participation rate flatters the unemployment rate.) Therefore, I force myself to find whatever the bright spots are in the economic data...

  2. Brian,

    Can you do a post explaining the impact of temporary open market operations and their impact on liquidity and risk? (

    Is the fed draining less and less excess liquidity through TOMO because market risk is increasing and therefore nobody wants to lend this excess liquidity?

    1. Hello, I am tied up with other work at the moment, but I could take a look over the next few days. As I worked for a Canadian firm, so I never got too close to the details of the U.S. money markets, other than a general awareness of how the repo market worked. (There was also an element of career development involved; a move from the bond portfolio to the money market portfolio was not considered a step up. Therefore, I did not want to appear too keen on the money markets...)

      But my initial guess is that you are broadly correct -- people want to get their hands on Treasury paper, so why lend it out? Also, firms that do not lend out their bonds may be buying, and so there is less supply. (There's a startup cost as well as increased overhead associated with getting involved with the repo market, so smaller firms quite often do not get involved with repo trading.)


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