Friday, September 18, 2015

Fixation on the Fed

The U.S. Central Bank, the Federal Reserve, commonly referred to as the “Fed” announced on Thursday that their Zero Interest Rate Policy or ZIRP, would continue.  Essentially, short term interest rates would remain at near zero.  

ZIRP and the other stimulus program used by the Fed called Quantitative Easing or QE, were put into place to stimulate the U.S. Economy.  

There are two valid reasons why the Fed would start unwinding both of these programs. First, increasing interest rates would tend combat inflation. Second, increasing interest rates would indicate that the economy is healthy and capable of supporting “normal” interest rate levels.

At least according to economic statistics provided by the government, inflation is under control. (Many would argue that these statistics are misleading.) But, in any case, the Fed does not see a need to raise interest rates to combat inflation.

The most important message sent by the Fed’s failure to raise interest rates is that they believe the global economy is not healthy and not capable of supporting “normal” interest rates. Sort of like a doctor saying “The patient is not in intensive care, but is still not well enough to be discharged from the hospital.”

So, in one way, the Fed’s inaction is a good signal for stocks and bonds—inflation will be low. But, on the other hand, it is a bad signal---the global economy is sick.

Couple that with the fact that Friday, September 18 is options expiration day and you get a lot of volatility.

Expect that until the Fed finally sends a clear message that “inflation is under control” AND “the global economy is healthy” markets will fluctuate up and down based on sentiment regarding what the Fed is likely to do next. 

What you should also remember is that the Fed does not control long term interest rates. Those are controlled by bond market sentiment. At least for now, the bond market agrees with the Fed—inflation is low and the economy is weak—so long term interest rates are low---at least for now. History teaches that bond market sentiment can change rapidly.