Fed to start tightening in the third quarter!

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The general consensus agrees with the minutes of the FOMC of January 26 that the highly accommodative monetary policy will be maintained owing to the expectation that the weakness in the labour market will persist for a long time and inflation is still below target. The FOMC expected to keep the fed funds rate near zero “for an extended” period. But will they?

I had a look at what triggered the Fed in the past to change direction in their monetary policy and especially the fed funds rate. No, it was not inflation nor was it employment as they profess. It was consumer sentiment! Over the past 22 years it is evident that the Fed changed policy a quarter after the Conference Board’s Consumer Sentiment Index crossed its 5-quarter weighted moving average. The only exception was in the third quarter of 2005 when consumer sentiment briefly fell below the weighted moving average.  Yes, they are chartists just like us!

Sources: Conference Board; I-Net; Plexus Asset Management.

The reason for the Fed’s behaviour probably lies in the fact that consumer sentiment normally leads core inflation by approximately ten months. A strong and sustained rise in consumer sentiment is therefore likely to lead to a higher core inflation rate ten months hence. In the current cycle, however, the core inflation rate kept on falling despite continued improved consumer sentiment. That can largely be ascribed to the continued weakness in the housing market and shelter in particular.

I am therefore of the opinion that a sustained improvement in consumer sentiment in the next few months will again see some hawks raising their heads in the FOMC as headline inflation is also turning for the worst. I would certainly start to bet on the Fed raising the fed funds rate in the third quarter of this year.

With consumer sentiment a major factor in the Fed’s monetary policy it is no wonder that the bond market slavishly follows the Conference Board’s Consumer Sentiment Index. The bond market obviously sees a stronger economy and higher inflation ahead.

It brings me to another point – where is the yield on the 10-year Treasury note heading? From the historical relationship between the 10-year yield and consumer sentiment over the past 12 years it is evident that the 10-year note at 3.62% is aptly priced given the current level (60.6) of the Consumer Sentiment Index.

A sustained rise (as I expect) in this index in the coming months is likely to take the yield on the 10-year note higher. Where it will top out I do not know but an improvement in consumer sentiment to 80 could see the yield rising to in excess of 4.1%. Obviously, bonds will rally if consumer sentiment surprises on the downside.

What about U.S. equities?

As in the case of U.S. bonds the U.S. market sentiment is significantly influenced by consumer sentiment. For market sentiment I used Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE) or PE10 for the S&P 500. It is similar to the standard price-earnings ratio but instead of dividing the current index by the past year’s earnings, it uses the average earnings of the past ten years. It is apparent that the equity market players are keen followers of consumer sentiment as it is obviously a major factor in their valuation models.

In light of the relationship between the Consumer Sentiment Index and the S&P 500’s CAPE the current CAPE of 23.7 indicates to me that a level of about 77 for consumer sentiment is priced in by the U.S. equity market. That compares with the current 60.6 (January).

If consumer sentiment comes in weaker than the 77, I doubt whether it will result in a major train smash as long as the number is much stronger than January’s. But what about inflation? Higher inflation was the reason why the S&P 500’s CAPE went sideways from 2004 to 2007 despite consumer sentiment rising further. I expect the same to happen when consumer sentiment hits the 85 level. A level of 85 transpires to an S&P 500 CAPE level of 26, though − up approximately 10% from the current levels.

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4 comments to Fed to start tightening in the third quarter!

  • David

    Who will buy the ever increasing flow of treasuries if the fed stops? The fed doesn’t dare tighten with 9% headline unemployment. I think that QE will continue, perhaps by another name.

  • robert

    I think consumer confidence had a rally up but like the economy is going to double dip. With all the states starting to get in the game of cutting it will have a huge spillover effect. If I was a consumer in the USA I would be wearing dependable’s for the next six months.

  • At some point the carrying costs of the Greatest Debt in the History of the World will become prohibitive.

    As long as rates remain very low US debt appears in some way manageable.

    But just how far can rates be allowed to increase under the present system before the world is forced to acknowledge an inconvenient truth: that the issuer of the worlds reserve currency is insolvent?

    The ‘official’ 14+ trillion dollar debt doesn’t even acknowledge the additional trillions of future “unfunded liabilities” that are coming down the pipe.

    I guess I’m wondering just how much tightening they can really get away with before they hurt themselves debt-wise.

  • Frank W

    I doubt a rate rise by the Fed, but then again what would I know. I also strongly doubt the effect of sentiment on anything.

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