Taylor Rule Targeting a Fed Funds Rate Below 2%?
(February 17, 2008)
Dear Subscribers and Readers,
I want to begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:
1st signal entered: 50% long position on September 7, 2006 at 11,385;
2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;
3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.
4th signal entered: 50% short position on October 4, 2007 at 13,956;
5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a loss of 281.79 points as of Friday at the close.
7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 633.21 points as of Friday at the close.
For those who want more frequent updates of our “thoughts,” I urge you to browse our discussion forum during the trading week – as this is where I communicate with our subscribers most often (and on a daily basis). In our latest discussion on the auction-rate market, we discussed how the municipal market, in particular, is still generally financially sound despite the current troubles – even if one takes into account the municipalities' unfunded pension and health care liabilities. This implies that – short of an “Armageddon scenario” – the municipal auction rate market should revert to normal once the bond insurers' debacle is resolved, most likely by the end of this week.
Let us now get to the heart of our commentary. In last week's commentary, I discussed the many fundamental and psychological reasons why we are currently 100% long in our DJIA Timing System (after covering our 50% short position that we initiated in early October at DJIA 13,956 in early January). With the benefit of hindsight, we now know that the Fed was “behind the curve” with their latest easing campaign. The Fed's reluctance to slash the Fed Funds rate aggressively during 2007 was one of the reasons why we decided to stay 50% short in our DJIA Timing System from October 4, 2007 till early January of this year. As Fed Chairman Ben Bernanke changed his stance in early January, and with the announcement of the Countrywide Financial acquisition in early January, it was apparent that the Federal Reserve, along with the Treasury, the FHLB, the GSEs, and other regulators, was actively “working behind the scenes” in order to bring the current credit crunch to a quick ending. In particular, the Fed committed to a much more aggressive timetable in its current easing cycle than it had in December.
Such a commitment by the Fed is integral to ending the current credit crisis. Recent empirical studies by the New York Fed has shown that financial institutions are typically “pro cyclical” – in that they tend to amplify financial/business cycles rather than dampen them. That is, they expand their balance sheets during a boom and shrink them during a bust. This tendency to be pro-cyclical results is what Soros would label the “boom-bust cycle,” or “reflexivity,” as financial institutions deleverage and as the trend followers increase their bets on the short side during a bust (part of this is also due to the utilization of VaR as a common risk management tool, as VaR tends to require participants to increase their leverage during a boom/low volatility period and to conversely shrink their leverage during a bust/high volatility period). Based on this concept, it is not difficult to understand why George Soros is now predicting the end of the “60-year super boom cycle” in a recent Financial Times editorial. The following figures (courtesy of the New York Fed) shows the sequences of a typical boom and bust cycle – in other words, what a typical business/financial cycle looks like in the pre-Fed intervention/cooperation days prior to World War II:
But again, the above virtuous/vicious cycles are not inevitable. First of all, it is to be noted that the history of George Soros' predictions are mediocre at best (when asked what he learned from running Quantum Funds with George Soros in the 1960s and 1970s, Jim Rogers responded that he learned that some traders can make money while still being wrong). For example, he made a similar prediction in the early 1980s when U.S. banks overextended themselves by lending to emerging market countries. Quoting his book, “The Alchemy of Finance”: “At the time of the international debt crisis I was working with a rather crude and inarticulate model of credit expansion and credit contraction similar to a boom/bust sequence in the stock market. I thought that 1982 was the end of a period of worldwide credit expansion and failed to anticipate the emergence of the United States as the “borrower of the last resort.”” I am not bringing this up as a criticism to George Soros' predictions, but merely to illustrate how inherently difficult it is to predict the collapse of a paradigm that has been in place for over 60 years – and how one erroneous assumption (in Soros' case, it was the U.S. coming in as a lender of last resort in 1982) can not only topple a model, but flip it on its head as well (in the case of 1982, the cleansing and bailout of the U.S. financial system preceded one of the greatest bull market in U.S. equities in history).
Second of all, while many folks are already crying that the Fed is “pushing on a string,” it is to be noted that monetary policy is not impotent. Rather, monetary policy usually takes a while (12 to 18 months) to “trickle down” to the real economy, and the Fed can only be regarded as “pushing on a string” to the extent that the target Fed Funds rate is set at a higher rate than what the Taylor Rule implies (as an aside, many analysts had also remarked that the Fed was “pushing on a string” in late 2002, only to reverse their call two years later and charged that the Fed had eased too aggressively). In particular, the NY Fed study asserts that rather than using money stock as a measure of liquidity (this indicator is only useful in a financial system dominated by deposit-funded banks), policymakers and analysts alike should instead pay heed to the growth rate of aggregated balance sheets of leveraged financial institutions, or outstanding repurchase agreements (this is why the Fed stopped publishing M-3 numbers, with the exception of one critical component: institutional money market funds). Moreover, the study asserts that based on empirical studies, repo growth can directly be attributed to the easing and tightening of monetary policy via the relation between the Fed Funds rate and the implied Fed Funds rate as dictated by the Taylor Rule. Quoting the NY Fed Study:
However, the ideal of a financial system dominated by deposit-funded banks may never have existed in its purest form, and it is becoming less relevant over time. Certainly, empirical evidence from the United States since the 1980s detects very little role for the money stock in explaining macroeconomic fluctuations. If the financial system is instead organized around the capital market, then conventional measures of money represent only a small proportion of the aggregate size of the leveraged sector. Nor is the quantity of deposits the most volatile component of the total aggregate liabilities of the financial system. In such a world, money is less useful as a measure of liquidity. The rapid move toward a market-based financial system in recent years has accelerated the trend toward greater reliance on nontraditional, non-deposit-based funding and toward greater use of the interbank market, the market for commercial paper, and asset-backed securities.
The concept of liquidity we proposed earlier—the growth rate of aggregate balance sheets or, more precisely, the growth rate of outstanding repurchase agreements—is a far better measure for a modern, market-based financial system than is the money stock. In this section, we focus on the question whether our preferred notion of liquidity has any bearing on monetary policy, and in particular whether the growth of repos is linked in a direct way with the easing or tightening of monetary policy. Our empirical tests of this relationship suggest that the answer to this question is a resounding “yes.” We find that repo growth is closely correlated with the ease or restrictiveness of monetary policy as measured by the Taylor rule. The Taylor rule specifies how a central bank should alter its targeted short-term interest rate (the federal funds rate in the United States) in response to evolving macroeconomic fundamentals—specifically, the divergence of current output from potential output and of current inflation from the desired rate of inflation. We show that when monetary policy is loose in the sense that the federal funds rate is lower than the rate implied by the Taylor rule, there is rapid growth in repos and financial market liquidity is high.
In other words, the decline in repo/liquidity growth due to the pro-cyclical policies of leveraged financial institutions can be directly arrested by monetary policy, as long as the Fed Funds rate is below the implicit Fed Funds rate as guided by the Taylor Rule, and as long as the Fed is able to credibly maintain the Fed Funds rate at that rate. It is to be noted here that in his recent editorial, George Soros is implying that the Fed cannot credibly maintain such a loose monetary policy, not because of inflationary pressures, but because he sees the end of the U.S. Dollar as the international reserve currency. In other words, Soros believes that should the Fed continue to lower the Fed Funds rate going forward, there is a good chance that the U.S. Dollar Index could dramatically fall.
At this point, however, we have seen no such pressure on the U.S. Dollar Index, even though the Fed has slashed the Fed Funds rate by a total of 225 basis points since September of last year. More importantly, even though the Euro Zone and the UK are still dealing with their own inflationary pressures, they – as well as Canada – have also provided implicit support to the current Fed easing cycle. That is, should “push comes to shove,” there is no doubt that both the European Central Bank and the Bank of England, along with the world's other major central banks, would coordinate a synchronized global easing cycle – as they have previously demonstrated when they worked together to inject much-needed immediate liquidity in the global financial markets back in August/September of last year. I believe this is where Soros has it wrong. As long as the U.S. Dollar, the Euro, the Pound Sterling, the Yen, and the Canadian Dollar collectively still occupy the dominant role when it comes to the world's financial markets and currency reserves held, and as long as these central banks continue to work together, the “60-year cycle” can go on for much longer than anyone could expect.
So assuming that the Fed has wide latitude to ease the Fed Funds rate further, what would be a credible target? At this point, the Fed Funds futures market is implying a 50 bps cut at the March 18th meeting, another 25 bps cut on April 30th, and one more 25 bps cut on June 25th. That is, by the middle of this year, the Fed Funds rate should decline a further 100 bps to 2.00%. Such a Fed Funds rate makes sense if one incorporates the Taylor Rule into the monetary policy decision. The same NY Fed Study – through an empirical study of the relationship between the growth of repurchase agreements and monetary policy – estimated the following Taylor Rule:
Federal Funds Target = 1.3 + 0.8 x Output Gap + 1.3 x Core Inflation + Taylor Rule Residual
The output gap is the difference between potential and current GDP. Based on the long-term rate of growth of the U.S. economy, as well as current population/productivity growth, the long-term sustainable potential GDP growth is around 3.0% on a real basis. Moreover, the study also separates the first three terms on the right side of the equation and defines them collectively as “rule-based” monetary policy, while the Taylor rule residual can be interpreted as “discretionary” monetary policy. In other words, a positive residual indicates tight monetary policy, while a negative residual indicates a loose monetary policy. Also, the R-squared of the equation is 75%, indicating that 75% of the variation in monetary policy can directly be attributable to the Taylor Rule, while the remaining 25% (the Taylor Rule Residual) is discretionary. Furthermore, the Taylor Rule Residual has a mean of zero and a standard deviation of 0.95, or close to 1%. In other words, it is not unusual to find the Fed Funds rate to be “overly tight” or “overly loose” on either side of the Taylor Rule by 1% - should the Fed want to dramatically slow or “jump start” the U.S. GDP growth.
Assuming that 1st quarter GDP growth has completely stalled, it is not inconceivable to imagine that the output gap has declined to -3.0% (assuming that GDP growth is now zero), or even to -3.5%, given the recent weak consumer spending and non-manufacturing ISM numbers. As for a credible core inflation input, let us now take a look at the six most recent readings in our various core inflation indicators, including the Cleveland Fed's median CPI and the 16% “Trimmed Mean” CPI:
Taking the average of the last six-month's readings – as well as an average of all four inflation readings, give us a rate of approximately 2.5%. Moreover, the 10-year TIPS derived expected inflation is currently at around 2.3%, as shown in the following chart:
Unfortunately, as the Cleveland Fed illustrates, the long-term inflation expectations as derived from 10-year TIPS is a biased estimator of long-term inflation – and on average, understates actual inflation by about 50 basis points. Taking this into account, it is not unreasonable to plug in a core inflation reading of 2.75% into our Taylor Rule equation as a credible alternative. Moreover, given that U.S. leveraged financial institutions are now actively shrinking their balance sheets and constraining liquidity growth, it is also not unreasonable to plug in some kind of “Taylor Rule Residual.” For the purpose of this exercise, we will look at three different scenarios – one with a zero residual, -0.5%, and -1% residual. Based on this equation as constructed by the New York Fed and the above assumptions, following are a dozen scenarios that the Fed is most probably looking at today:
If we assume that the Fed's aim is not to “counter-act” the pro-cyclical forces of U.S. leveraged financial institutions, then the “right” Fed Funds rate is somewhere in between 1.75% and 2.50% today. That is, even by this measure, a 3% Fed Funds rate is still overly tight, especially since the ECRI's Future Inflation Gauge is still near a multi-month low. However, such a policy does not currently jibe with what the Fed has communicated and what the Fed should do to prevent a widening of the credit crunch. Given today's situation, and given recent Fed speeches, it is reasonable to assume at least a Taylor Rule Residual of -0.5%, if not -1%. In such a scenario, the “ceiling” on the Fed Funds rate would be 2% (or 1.98%, as illustrated in Scenario 6). On the downside, it is not unreasonable to believe that the Fed could ultimately cut the Fed Funds rate to as low as 0.75%. In fact, unless U.S. economic growth accelerates in the coming weeks, there is reason to believe that the 2% Fed Funds rate that is current priced in by the futures market (by the middle of this year) is actually not low enough. Should the stock market continue to vacillate at current levels over the next four weeks, and should housing prices decline further (which is pretty much a given), then I would not be surprised to see the Fed ease by 75 basis points at the March 18th meeting, as opposed to the 50 bps that is currently priced in by the Fed Funds and the Eurodollar futures markets. In the meantime, subscribers should continue to look for volatility and uncertainty to rein in the stock and financial markets.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2006 to the present:
For the week ending February 15, 2008, the Dow Industrials rose 166.08 points while the Dow Transports declined 8.96 points as oil prices continue to rise. The latest weekly non-confirmation of the Dow Industrials by the Dow Transports on the upside is the first such non-confirmation since mid December. That being said, the Dow Transports –with its 13% rise over the last four weeks - is still exhibiting greater relative strength than the Dow Industrials at this point, and given that the Dow Transports has been the leading index since this cyclical bull market began in October 2002, there is a very good chance that we have already seen a bottom on January 22nd, even though retail investors should continue to be jittery over the next several months. For now, we will stay 100% long in our DJIA Timing System.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators declined slightly from last week's reading of -8.1% to -8.3% for the week ending February 15, 2008. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
Note that the four-week MA – excluding the -8.4% from two weeks ago is still at its most oversold level since April 2003. Moreover, the four-week MA has now been below the -8% level for the last three consecutive weeks – something that has not occurred since the late March to April 2003 period. Also, the 10-week MA (not shown) again declined – from last week's 1.4% reading to -0.5% this week – representing its most oversold level since early May 2003. Given this and other factors we have previously discussed, I continue to be comfortable with a 100% long position in our DJIA Timing System, and will most likely not par back until/unless we see the stock market or these sentiment indicators get overbought again, or should the fiscal stimulus be not implemented in time for the checks to start arriving by May,
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
With the 20-day moving average of the ISE Sentiment Index declining to 97.6 (after hitting a low of 96.6 earlier in the week, or its most oversold level since October 28, 2002) and the 50-day moving average declining to 106.8 in the latest week, the ISE Sentiment Index is now extremely oversold and has “sold off” to a level that is close at or close to the October/November 2002 lows. Given the capitulation bottom that we saw on January 22nd, the immensely oversold conditions as confirmed by the NYSE ARMS Index and the new highs vs. new lows on the NASDAQ Composite, and the promise of more cuts in the Fed Funds rate to come, I believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500. For now, we will stay with our 100% position in our DJIA Timing System, and will most likely only scale back if we get a spike in our most popular sentiment indicators.
Conclusion: Based on the Fed's empirical studies, including the impact of monetary policy on repo/liquidity growth and the implications of the Taylor Rule, it can be argued that a Fed Funds rate of 3% is still overly tight, unless the various U.S. leading indicators (per the ECRI, Conference Board, the UCLA Anderson Forecast, and the OECD Leading Indicators) start turning up over the next few weeks. This is the price that the Fed must pay for being “behind the curve” all through last summer and the end of 2007. That was one reason why we remained 50% short in our DJIA Timing System during the entire fourth quarter of last year, and why remained 50% short earlier this year – that is, until the Fed changed its stance in mid early to mid January. This also implies that the Fed should continue to cut the Fed Funds rate more than many analysts are currently discounting. I would not be surprised if the Fed slashes the Fed Funds rate by 75 basis points at the March 18th meeting or if we ultimately see a Fed Funds rate below 2% sometime later this year. Make no mistake: Monetary policy will ultimately work, but as dictated by the Taylor Rule and the various Fed studies out there, the Fed Funds rate would need to be substantially lower until we see liquidity growth again. For those who still have doubts, consider just one minor aspect: Should the Fed cut the Fed Funds rate to 2% by the April 30th meeting, this would effectively mean that any subprime mortgages that were going to reset after April 30th would actually see a DECREASE in its mortgage payments, not an increase as most folks have previously projected (including this author). Again, at this stage, unless the stock market or sentiment levels get overbought again, this author would only pare back our 100% long position in our DJIA Timing System should the Fed scale back its easing campaign going forward.
Finally, with the vast majority of our contrarian/sentiment indicators still hitting multi-year lows, and given the Fed's accommodative stance and the immense amount of cash currently on the sidelines (which we have discussed in our last several commentaries), chances are that we witnessed a significant bottom on January 22nd. While anything can happen in the short-run, we believe that there is a little downside in U.S. (and Japanese) equities at current levels. For long-term investors, the market continues to be a “buy.”
Henry To, CFA