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Fed's Dissenter May Foreshadow Interest Rate Rise

1 August 2014 in Trading Ideas

At the surface level, the actions of the Federal Reserve this week were on par with expectations.

The Fed announced, as expected, that it would reduce its monthly bond purchases of $25 billion, and it gave little indication that recent signs of stronger economic growth had changed its mindset of holding short-term interest rates near zero until 2015.

The central bank had already announced that it planned to stop buying more bonds in October after a penultimate purchase in September. The looming question, at that point, was to be how long it would take for the Fed to raise interest rates.

While that decision continues to be uncertain, a noteworthy development this week, as the New York Times pointed out, was that the Fed’s decision was 9-1 – not unanimous – and offering new Fed President Janet Yellen her first metaphorical “defeat” at the hands of Philadelphia Fed President Charles Prosser, who said he thought the intention to keep rates low after the end of the bond-buying program did not reflect “considerable economic progress.”1

 

Plosser’s vote followed an editorial published earlier this week in the Wall Street Journal that voiced concern about the central bank staying “too loose, too long.”

As the Financial Times noted, Plosser’s dissent marks the start of what is likely to be escalating tension within the Fed, as the employment situation slowly improves and an ultimate interest rate rise draws near.2

And, while interest rates on the 10-year Treasury bond shot higher on Wednesday, the yield is still well below its 200-day average and is much closer to its lows of the past 12 months.

That said, expectations that rates will eventually head higher have had their impact. The Rising Interest Rates motif, a portfolio of stocks of custodian banks and brokers, has gained 5.2% in the past month. Over that same time, the S&P 500 is up 0.6%.

In the past 12 months, the motif has increased 17%; the S&P 500 has advanced 19.3%.

Some Fed officials see evidence that the economy is settling into a new pattern of modest growth, and that monetary policy has substantially exhausted its power to improve the situation, the Times said. They want the Fed to retreat more quickly from its stimulus campaign, fearing that holding down interest rates will result in higher inflation, or that it will encourage excessive risk-taking by investors.

But Yellen and her allies have taken a more cautious view, arguing that the decline in the unemployment rate appears to overstate the improvement in the labor market, because it counts only people who are looking for work. As the Times noted, Yellen expects some people who dropped out of the labor force to return as the economy continues to improve, and she has pointed to tepid wage growth as evidence that it remains easy to find workers.

As she told Congress this month, “the recovery is not complete.”

The question for equities investors, however, is whether it’s complete enough for a sustained rally in interest-rate sensitive stocks.

1Binyamin Applebaum, “Fed, On Target to End Bond Buying, Stresses Concerns On Job Market, nytimes.com, July 30, 2014, http://www.nytimes.com/2014/07/31/business/economy/federal-reserve-policy-decision.html.

2Robin Harding, “Janet Yellen sees first dissent in favour of Fed tightening, ft.com, July 30, 2014.

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