In The “All Else” Part 2, with a little on the Fed, I covered the very basics of how interest rates can impact stock prices (just redid the whiteboard presentation—made it much clearer and shorter—take another look). Today’s essay is all about the Fed, and why it’s such a big deal for the stock market.

When you hear “the Fed” in the news these days, chances are you’re hearing about the Federal Open Market Committee (FOMC), as opposed to the Federal Reserve System itself. So our topic for today is the FOMC.

But first, here’s a little bit about the Federal Reserve:

Founded in 1913 for the purpose of implementing monetary policy. It’s headed by the Board of Governors of the Federal Reserve. The Board of Governors consists of seven appointees who each serve 14 year terms. The Board is led by a chairperson, presently Janet Yellen. There are a total of 12 Federal Reserve Banks located in major cities—they are the operating arms of the central bank. They earn their keep by providing services to banks, earning interest on government securities, earning interest on loans to banks, and any income from holding foreign currencies. Profits go to the U.S. Treasury.

The FOMC:

Janet Yellen, is also the present chairperson of the FOMC, which is the policymaking branch of the Federal Reserve. The FOMC’s voting members consist of the seven Fed governors, the president of the Federal Reserve Bank of New York and the presidents of the other four Reserve Banks who serve on a one-year rotating basis. The remaining Fed presidents serve, but don’t vote on interest rate policy.

Suffice it to say that Ms. Yellen and her fellow board members have their work cut out for them. They have been assigned a “dual mandate”—which, in a nutshell, is stable prices and full employment. Now, given that the Fed has no items to sell, or, therefore, price, and it’s not in the market for additional labor, they really do have their work cut out for them.

Well, actually, it does have one thing to sell and, therefore, price. And it happens to be a very big thing, the U.S. dollar. They raise and lower the price of the dollar by raising and lowering its quantity. They can produce it at will, then deposit it into banks’ reserve accounts, in exchange for fixed income securities, like treasury notes. One result of increasing the supply of reserves in the banking system is a lowering of the cost of borrowing (interest rates). The Fed does this when it needs to boost employment—and/or to ward off deflation—by boosting the economy. I.e., in theory, when money is cheap (when interest rates are low), people will spend it—and stimulate the economy in the process. If, or when, the economy begins humming along at a pace that production can’t quite keep up with, inflation ensues. Which of course threatens the Fed from a “stable prices” perspective. To ward off the threat of inflation (higher prices), the Fed will reverse course and begin extracting dollars from the banking system (selling securities back to the banks)—i.e., reducing supply. Reducing the supply of money, all else equal, means raising the cost of borrowing (higher interest rates). I.e., in theory, when money is expensive, people will spend less and the economy will slow—and inflation will wane.

Oh, if it were only that simple—if all the Fed had to do was deposit and withdraw reserves from the banking system to keep prices steady and jobs aplenty, the life of a Fed Governor would be peaches.

Now, there’s not nearly enough space here for me to go off on a tangent about how ineffective, and effectively dangerous, all this money manipulation can be—so for now I’ll simply pause here and give you a beautiful Friedrich Hayek quote (from his Nobel Prize Lecture):

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

Alas, the Fed goes way beyond providing the appropriate environment—it messes with the weather. And that’s what creates the messiest of storms, like the recent real estate/credit bubble.

Back to what they do: The FOMC has many tools at its disposal with which to attempt to fulfill its dual mandate. Including, but not limited to:

*As stated above, the buying and selling of fixed income securities in the open market (hence, dubbed “open market operations”), which injects cash into, and extracts cash from, the system—thus raising and lowering interest rates in the process.
*It pays banks interest on the excess reserves it holds for them. It can raise that interest rate (pay them more) when it wants the economy to slow down (interest rates rise), it can lower that rate when it wants to stimulate the economy.
*It sets reserve requirements for the banks. It can lower banks’ reserve requirements to free up cash to lend, in an effort to stimulate the economy—it can raise reserve requirements to tighten up the supply of lendable cash, in an effort to cool the economy.
*It can sell holdings out of its massive chest of securities should it decide to cool things down.
*It can raise or lower the rate at which it lends directly to banks (the discount rate).

We could dig deeper into the weeds in terms of all of the Fed’s machinations, but in the interest of keeping you awake I’ll cut to the chase and explain why I pay attention to the Fed:

The fact that the Fed has the power to create money means that it can do all sorts of strange and wonderful, and not so wonderful, things to the economy. And, therefore, investors, and/or their advisors, must forever formulate their opinions of what the Fed is presently up to, and what it’s likely to do in the foreseeable future. Clearly, there is no small number of traders out there who are keenly focused on the Fed. It seems that the merest hint that it might raise short-term rates sooner than, say, the second half of 2015, sends the market—by nature of traders exiting—into a tizzy. Conversely, any indication that it has no interest in taking away the punchbowl anytime soon, seems to get greeted with—by nature of traders buying—a nice rally.

The funny thing about what I just stated is what either of those scenarios actually says about the economy. Should, for example, the Fed declare tomorrow that it’s ending its monthly bond buying program (quantitative easing [QE]) now, and raising the Fed Funds rate by a quarter point—while the market would surely tank—it would be making a substantially bullish statement about the economy. It would in essence be saying that the economy is finally taking off and that the Fed is ready to attempt to normalize interest rates. Now you’d think that would be good for stocks, but, in the short-run, I assure you it wouldn’t. In the long-run, however, it—“normal” rates—would absolutely be a good thing… And, conversely, should the Fed announce that it’s going to cease the tapering of QE (which they’ve been doing by $10 billion a month since January), and that it expects to keep rates low out to, say, 2017—while the stock market might rally—that would be an ominous statement about the present state of the economy.

In my view, rising interest rates are not only a possibility, they’re an inevitability. The Fed’s recent success at keeping them at record lows concerns me in terms of when and how violently the bond market will ultimately give way to reality. Most market participants (investors, advisors, fund managers, traders, pundits, etc.) seem very sanguine about the bond market these days. Me, not so much. Regular readers/listeners may recall that on several occasions last year I pulled back from my bond bubble concerns—my reasoning was that, at the time, it seemed like everybody was finally on board with that worry (that the bond bubble would burst [and interest rates would spike] all over the economy). It’s been my experience that the widely anticipated disasters tend not to occur—but rather, it’s the things no one sees coming that do the real damage. The fact that, these days, “everybody” seems to have dropped the bond bubble story (some pretty smart people are predicting that bonds could even rally [sending interest rates even lower] from here) puts it back on the table for me.

In any event, whether it’s a bond market collapse, or a slow, stodgy recovery in interest rates, stocks—some sectors more than others—are interest rate sensitive. Which will indeed influence our sector recommendations in the months and years to come. Which is one reason why we watch the Fed…

Stay tuned…