Fed Gives Investors What They Wanted, But Is It Enough to Keep Stock Rally Going? – Published in Noozhawk on Monday, September 22, 2014

Last week, the Federal Open Market Committee of the Federal Reserve Bank met to discuss the U.S. economy. Investors anxiously waited for the statement following the meeting for direction from the Fed regarding the timing of interest rate increases to come. A question of when and not if, the Fed will certainly begin raising short-term interest rates in 2015. The timing of the beginning of those rate increases is the hot topic of the moment for investors.

The key language in the previous Fed statements has been “considerable time,” referring to the amount of time that the Fed will wait from when it removes the last of the stimulus from QE3 (quantitative easing round 3) — which should be within the next six weeks — and when it begins raising short-term interest rates.

Investors were relieved and encouraged when the Fed left the considerable time language in its statement, and stocks rallied to new all-time highs for the Dow Jones Industrial Average and Standard & Poor’s 500. As expected, the Fed also announced a reduction on $10 billion, to $15 billion from $25 billion in bond purchases to continue until the next Fed meeting, at the end of October, at which it plans to remove the remaining stimulus (assuming the economy continues to improve).

Although it is likely that stocks and bonds would have felt the sting had the Fed removed the considerable time language, we know that the clock is ticking — interest rates are going to increase, sooner rather than later. Not only will they move higher, but once the Fed begins raising short-term rates, the pace of the increases will be brisk.

A majority of the 10 Fed officials expects interest rates to rise to a median rate of 3.75 percent by the end of 2017, according to the central bank’s updated “dot plot.” Only four expect rates to be below that threshold. According to the new plot, Fed officials now expect the midpoint of the Fed funds rate to be 1.375 percent at the end of 2015, up from 1.125 percent. If the Fed waits until the middle of 2015 to begin raising rates from zero percent currently, the ace of rate increases will be frantic. The dot pot shows rates rising to 2.875 percent by the end of 2016, up from 2.5 percent from the previous forecast.

In addition to removing the bond purchases from QE3, the Fed continues to reinvest cash from maturing bonds in its bloated $4.4 trillion portfolio. In the statement last week, the Fed indicated it plans to continue reinvesting proceeds from maturing assets until it begins raising rates. The result of this will likely be a double-whammy effect on markets, once the Fed pulls the trigger on rate increases and stops reinvesting proceeds from maturing bonds at the same time, around the middle of next year.

Investors still appear to be focusing on the very short-term — days and even hours, versus looking at the long-term trends for the markets. As a result, both the stock and bond markets are grossly overextended and ripe for major corrections/crashes. While bubbles can form and persist for months or even years, ultimately they must burst. The larger they get, the more dramatic — and painful — the aftermath.

The clock is certainly ticking on the Fed’s next move on interest rates. Whether it comes in the first, second or third quarter of next year, there is no doubt that rate increases are coming, which means in a matter of months. Corrections and crashes, when they come, come fast and fierce. There will likely be little or no warning, and the trigger will likely be something that normally (in a market that was not in a bubble) would be insignificant.

Those committed to a buy-and-hold strategy can sleep well at night knowing they are locked into their strategy, for better or for worse. Everyone else, and especially those with less than a 10-year time horizon, should take action to protect portfolios from adverse moves in asset values.

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