Why The Markets Should Be Less ‘Fed’ Up
Today, as expected, the FOMC voted to keep short-term rates steady at 1.00%.
Most importantly, however, by being more explicit about its policy goals, the
Fed is giving the financial markets–which have been very confused about the
Central Bank’s intentions as of late–a better indication about what to expect
in the foreseeable future. To be specific, in its carefully worded statement,
the Fed is confirming that economic growth is indeed picking up, while at the
same time, declining inflation will allow it to keep rates low for a
“considerable period”–as opposed to the more ambiguous “for as long as
necessary” choice of words used in the last policy statement. In my view, this
clarification on the Fed’s part should help ease the selling pressure in the
Treasury markets for the time being–though the long-term trend is higher–while
allowing the S&P 500 to continue on its path higher through the end
of this year.
As evidenced in the chart below, the implied rates of the Fed Funds futures
contracts immediately lowered after the statement was released. However, the
market is still too aggressive with its expectations for a rate increase down,
as it now expects a rate increase by next April. By comparison, in the early
90’s when the Fed went on a rate cutting spree, in an effort to lift the economy
out of a recession, it waited 13 months before it began tightening rates.
According the the futures in the chart below, the current lag between rate
cycles would only last 10 months, which again, is far too soon. The reason is
capacity utilization.
 Capacity utilization measures the amount of resources being used by the
economy. A high number indicates that the available resources are being
stretched, and low numbers indicates the opposite.
What does this have to do with rates?
Typically, when capacity utilization is high, inflation becomes a concern for
the Fed. The reason is that it becomes increasingly difficult for firms to
produce enough to meet additional demand for their goods when they are using all
of their available resources. And when demand exceeds supply, inflations begins
to appear. In order to prevent inflation from taking hold of the economy, the
Fed slows demand by raising rates (higher borrowing costs).
As evidenced in the chart below, capacity utilization is at 74.3, which is
low by historical standards–lower than during the early 90’s. The chart also
illustrates the relationship between high levels of capacity utilization and Fed
tightening cycles. Typically, the Fed raises rates when capacity utilization
rises above 81. It would take explosive economic growth (above the most
optimistic forecasts) for capacity utilization to rise above 81 from 74.3 in
just 10 months. As the market realizes this, the short end of the yield curve
should come in some more and Treasury yields should settle down here for the
time being before moving higher in the months ahead.   Â
Some market observers have expressed their doubts that an economic recovery
(and further stock market gains) can occur given the low level of capacity
utilization. However, as can be seen in the chart below, there have been two
periods in the past 30 years when capacity utilization was lower than it is now
(in the mid 70’s and early 80’s) and the economy (and corporate profits) grew.
In fact, on both occasions, profits actually rose before capacity utilization
bottomed out–similar to what is now happening. Moreover, forward earnings are
now up sequentially for 26 weeks; economic data continues to firm; and the
credit markets–though weaker than they were a few weeks ago–have stabilized.
So equity investors should therefore remain encouraged.
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