There have been prior indications – though Wall Street brushed them off. During Fed Chair Janet Yellen’s testimony to the Senate Banking Committee in mid-July and in the Fed’s Monetary Policy Report, some of the most glaring bubbles that the Fed has so strenuously inflated since the Financial Crisis suddenly appeared on the Fed’s official worry radar.
Yellen lamented “valuation metrics” of stocks that appeared “substantially stretched.” She pointed at biotech and social media. PE ratios were “high relative to historical norms.” She even acknowledged the greatest credit bubble in history by fretting about the “‘the reach for yield’ behavior by some investors” and how “risk spreads for corporate bonds have narrowed and yields have reached all-time lows.” And she bared the disconnect between the markets and the Fed: increases in the federal funds rate “likely would occur sooner and be more rapid than currently envisioned.”
Other Fed heads have chimed in with warnings of their own, telling the markets that rates could rise sooner and more rapidly than the markets were pricing in. But it all fell on deaf ears. Stocks have risen since, including the very sectors that Yellen tried to prick, and yields have dropped.
But now the San Francisco Fed got down and dirty, using actual evidence of sorts to make the point that this isn’t just idle banter. It seems these folks are getting serious about manipulating the markets into acknowledging that QE Infinity was just temporary and that ZIRP – the foundation of the economy for so long that no one can even envision life without it – would fade away.
And they chastised the markets that so eagerly believed all the promises of QE Infinity and eternal ZIRP for not believing the end of ZIRP. They’re worried about the market’s reaction if there is a sudden recognition, rather than a gradual one, that the endless manna would end. They’re worried about financial instability.
And so two economists of the San Francisco Fed issued another warning about the disconnect between where the Fed is going and what the markets want to believe:
An ongoing concern has been that the public might misconstrue the Fed’s forward guidance about future monetary policy and underappreciate the extent to which short-term interest rates may vary with future news about the economy. Evidence based on surveys, market expectations, and model estimates show that the public seems to expect a more accommodative policy than Federal Open Market Committee participants. The public also may be less uncertain about these forecasts than policymakers.
Yellen herself, they wrote, had fingered low “volatility” – the idea that assets only go up, rather than up and down – as a hazard and that “some investors may underappreciate the potential for losses.”
The markets simply haven’t taken the Fed’s cues about rate increases seriously and might be taken by surprise, which could cause a violent reaction, hence market instability. To make sure that this time, investors get the message, they added:
Prices of financial assets, such as stocks and bonds, are sensitive to unexpected changes in interest rates because their present values are determined by discounting future cash flows. Thus, the low volatility in asset markets could, in part, reflect market participants’ relative certainty about the future course of interest rates.
False certainty, they point out.
The Fed has been using its forward guidance to jawbone markets into doing what the Fed wants them to do. It worked like a charm in trying to inflate the greatest credit bubble in history, along with a magnificent stock market bubble, even another budding housing bubble [Who the Heck Is Going to Buy all these ‘Overpriced’ Homes?].
But now that the Fed is trying to jawbone markets into the other direction, it suddenly isn’t working anymore.
Markets aren’t giving “enough weight to how dependent the central bank’s guidance is on both current and incoming data,” they complained. “Thus, the public could underestimate the conditionality and uncertainty of interest rate projections. And that was an “important concern.”
To demonstrate the disconnect with semi-hard data, they compared the federal funds rate projections of FOMC members, based on the Summary of Economic Projections (SEP) in June, to where market participants think the rates will be. To get a grip on investor expectations, they used three sources: surveys of economic forecasters and primary dealers; market prices of federal funds futures; and estimates from a financial-econometric model.
They found that market participants’ expectations of the Fed funds rates going forward were out of line with the projections from FOMC members themselves. Market participants were pricing in “a later liftoff date” for ratcheting up the federal funds rate and a slower pace of tightening, and they were relatively certain about it, in line with their certainty that stocks and bonds would always go up. They were in fact more certain “about the future course of monetary policy than FOMC participants.”
Don’t fight the Fed?
After years of using its scorched-earth monetary policies to engineer the greatest wealth transfer of all times, the Fed seems to be fretting about getting blamed for yet another implosion of the very asset bubbles these policies have purposefully created. And it is harnessing various resources, from Yellen on down to some economists at the remote San Francisco Fed, to spook markets into backing off gradually, rather than all at once. But for now, these markets can’t be spooked – not by the Fed, and not by anything else.
With home prices rising for three years across the country and soaring in a number of metro areas, the inevitable is happening: sales stalled. Something has to give. And it’s not going to be maxed-out American consumers. Read… But Who the Heck Is Going to Buy all these ‘Overpriced’ Homes?
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