Fed hike could precede bubble, not pop it

6 min read

Sure the Fed is going to hike, but maybe not high enough and quickly enough to impair one of the few of their tools which actually still works: rising equity prices.

It is reasonable to expect the Fed on Wednesday to drop hints about an initial rate hike later this year, likely in September. It is also fair to expect a campaign of tightening to involve regime change in financial markets, not just tough times for bonds but also a contrary wind for equities.

What is less clear is whether the Fed will be willing to raise interest rates quickly enough to offset the potential for a damaging equity bubble later in the cycle.

While changes in the supply of money have less economic impact than they used to, blunting the traditional tool central banks use to influence inflation, employment and growth, there has been a bull market since the financial crisis in one thing: financial assets. That’s in large part because of official policy.

“This sustained stimulus through unconventional monetary policies has led to quite inflated asset prices, forcing the Fed to face an increasingly difficult choice of validating the economic recovery without undermining the stability in the asset markets,” Stephen Jen and Fatih Yilmaz of hedge fund SLJ Capital write in a note to clients.

“The temptation for the Fed officials to continue to focus on the short-term cyclical challenges will most likely mean later and slower rate hikes, which in turn will increase the risks of a significant financial market event sometime in the future.”

On SLJ’s calculations, Fed policy is responsible for more than half of the volatility, or day-to-day movement, in stocks, compared to just 10% to 15% two decades ago.

To put it in perspective, the federal funds rate, the dollar and the money supply, three variables controlled or strongly influenced by the Fed, are now more important in driving equity movements than US corporate profits, global GDP and inflation combined.

In other words, the Fed is riding a tiger in equity markets: its power over them, and because of them, is greater, but its ability to allow them to go their own way is severely impaired.

That means that the temptation must be for the Fed to wait too long and hike too little. Surely the US central bank, and most observers, want them to get interest rates off of the floor, but given the improvement in employment and signs of better wages and inflation coming through, that may not be enough.

Not a bubble, yet

Andrew Garthwaite and equity strategists at Credit Suisse argue that while we are not in an equity bubble now, we have a 60% to 70% chance of seeing one form later in this financial cycle.

“Bull markets in most assets end in bubbles; despite Fed tightening this year, central banks are likely to keep policy abnormally loose,” Garthwaite wrote in a note to clients.

The Fed may fear that it will pull the rug from under the recovery, and it may be banking on a dollar rally to do some of its tightening for it, hopefully in a way that keeps a lid on financial froth but without cratering the stock market.

To be sure, the Fed might upset this expectation by moving aggressively to tighten, especially if wage growth looks set to spark an inflationary reaction.

With US equities trading at just under 17 times annual earnings, stocks are expensive now, about 1 standard deviation above their 10-year moving average, according to Credit Suisse. That’s actually lower than where they were in the October 2007 peak, and much lower than the average 19.6 p/e ratio of US market tops since 1929.

Looking at some of the traditional markers of a bubble, US stocks don’t really qualify. Merger and acquisition activity is up and actual profits, as opposed to those companies report, are falling, both negatives.

What isn’t in evidence, outside of Silicon Valley and the untraded ‘unicorn’ sector, is millennial, this-time-it-is-different thinking. Most investors are quite jaded towards equities and share a certain amount of cynicism about the impact of monetary policy.

That’s meant, especially in the US, that retail investors have been sitting much of this rally out. More than $80 billion has flowed out of equity mutual funds since 2009, for example. Investors are also still paying attention to fundamentals, with the normal link between earnings and stock movement still holding.

None of this is to say that the first Fed hike, which is surely coming, won’t be met with dismay by equity markets. That nearly always happens and is to be expected.

Compared to an earlier world, though, the Fed has plausible reasons which might lead it to make a mistake and keep conditions too easy.

It wouldn’t be the first bubble brought on by monetary policy, and surely not the last.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)

James Saft