Why Not 50?

Asking if the Federal Reserve will lift the federal funds rate on June 13 is like asking if Las Vegas Golden Knights goalie Marc-Andre Fleury, who has stopped 94.7% of the shots against him in the 2018 Stanley Cup playoffs, will stop the next one.  It’s a virtual lock.

And everyone knows the rate hike is almost guaranteed to be the very same 25 basis point (bp) increment the Fed has used six times in the current rate hiking cycle, starting in December 2015.  In fact, that’s the same 25 bp increment the Fed used consistently between June 2004 and June 2006, totaling seventeen drip-drip-drip rate hikes in all.  That campaign lifted rate 425 bps total, every one of which was telegraphed.  Rates moved from a starting point of 1% to a peak of 5.25%.

We need to go all the way back to May 2000 to find a meeting at which the Fed raised rates by 50 bps – the final rate hike of that cycle – after a series of 25 bp hikes that started in mid-1999.  In other words, the Fed has become comfortable and predictable with 25 bp moves, which seems to be all about not getting blamed for any kind of short-term market turmoil.

So why not raise by 50 bps?

Everyone knows the Fed will lift rates by at least another 50 bps this cycle.  The federal funds futures market puts the odds of the Fed raising rates by less than 50 bps this year at 6.6%.  We’re sure the odds would be even lower if we included 2019.  That’s as close to a sure thing a Marc-Andre Fleury.

So, if the Fed is going there anyhow, why not get there sooner?  Why not get to a neutral monetary policy more quickly?  Why be so predictable?

Raising rates by 50 bps this early in the cycle isn’t going to make monetary policy tight.  Right now, nominal GDP (real GDP growth plus inflation) is up 4.8% in the past year and up at a 4.4% annual rate in the past two years, well above the current federal funds target of 1.625%.  The 10-year Treasury yield is about 145 bps above the funds rate.  Meanwhile, the banking system is chock full of excess reserves and a record amount of capital.  Congress and executive agencies are moving to undo some of the excess regulations on the banking system, there are no major bubbles in the financial system, and corporate balance sheets are in fantastic shape.

Add in an unemployment rate of 3.9%, well below the Fed’s consensus view that its long-term average will be 4.5%.  Plus, the PCE deflator, the Fed’s favorite inflation measure, is already up 2% from a year ago and, given the recent rise in oil prices, should hover persistently above 2% for the rest of the year.

One of the key problems with “forward guidance” and gradually lifting interest rates on a predictable schedule is that it’s too predictable.  It’s like clockwork.  At present, everyone thinks they can predict the movement of future short-term rates with little to no risk.  Which is exactly what happened in the previous decade.  By telegraphing every move, the financial system could use simple spreadsheets to build a strategy for taking advantage of 25 bp moves at every meeting.  This led to a complacency and a willingness by many players to take on excessive risk.  In many ways, this is the same thing President Trump complained about with our military – always telling the world exactly what we would do and when we would do it.

To be precise, we’d like to see the Fed raise rates by 50 bps in June.  Then, using its dot plot and press conference, the Fed could signal more rate hikes to come while also, by going 50 bps at this meeting, signal that timing is always on the table.    In other words, the Fed would probably raise rates by a total of 100 bp this year, but the average level of short-term rates in 2018 would be slightly higher than if it moved only 25 bps at a time.  This would move long-term rates higher sooner as well.

Surprising the market would not be the end of the world.  Back in September, the Bank of Canada surprised with a rate hike and lived to tell the tale.  Canadian equities are up since then.  And the Canadian dollar is up, as well.

Once again: we’re not holding our breath waiting for the Fed to surprise the market.  The most likely outcome on June 13 is yet another 25 bp rate hike.  But if the Fed really wants to prevent the kinds of imbalances that built up before the last recession, it should consider introducing some upside uncertainty into the path of short term rates.

Eric Ludwig is a certified financial planner in Madison, WI primarily for a select group of successful professionals and business owners, who among other things aspire to a work-optional lifestyle.  Stockbridge has developed and refined a process to put all the pieces of that puzzle together and we call it the Stockbridge GPS process.  GPS stands for Goals, Planning, Strategy.

When NASA launches a spacecraft to land on the moon (yes, I know that’s been awhile) what percent of the time does it spend on its intended path?

It’s only 3% of the time.  The Apollo missions took about 3 days to reach the moon. This means that out of the 3 days to reach the moon, they were on their intended path for only about 2 hours!  That’s it!  What the heck does that have to do with investing?  I think it’s a worthwhile analogy.

As humans, we set goals, whether it’s going to the moon, buying a house, saving for college or being independently wealthy.  Goals are so important because it guides our actions and it gets us moving in the right direction.  Apollo was only on its exact intended path 3% of the time, but its trajectory, it’s path, was always moving closer to the moon.  (if you’re a bad golfer like me, you know the feeling)

And so is the case with financial goals.  When we run a projection for a financial plan that earns 6% per year, that does not mean we will earn 0.0238% per day.  Investing doesn’t work that way.  Sure, there will be some days that we earn exactly 0.0238% in one day, but I have a feeling that occurs even less often than Apollo was on track towards the moon.  It’s more likely that we have days like today: the Fed raises rates, your portfolio jumps 1.28% today.  Tomorrow it goes down a little, and on and on.

But daily returns don’t matter.  Frankly, monthly, quarterly, and semi-annual returns aren’t the most important thing either.  Those are just results.  That’s the scoreboard.  What matters is that we’re taking the right actions towards our goals, and making course corrections along the way. That’s even how our investment models work: making adjustments as we adapt to changes in the global markets.  We will experience down days, months and quarters along the way.  As investors, we shouldn’t be surprised by that, we should expect that.  That’s how investing works.  Volatility is just part of the process.  If your account didn’t fluctuate, you’re either one of Bernie Madoff’s clients or sitting in cash.

That’s why focusing on process is so important (vs results).  Goals change as we have new experiences.  The goals we had when we were 5 changed by the time we were 15, and changed when we were 25 as we had new experiences along the way.  But at least goals put us on the right trajectory towards the things that are most important to us in life.  A cool exercise: think about a goal and then ask yourself “if I accomplish that goal, what will that mean to me.”  For example, goal: have a million dollars. What will that mean? I’m rich.  What will that mean?  I don’t have to work anymore.  Why is that important?  I can spend more time with my family, exercise, and hiking.  Ahhhhhh….now we’re on to something.

General advice: Think big.  As someone once said “aim for the moon.  Even if you miss, you’ll still land among the stars” …even if we’re off track 97% of the time.

Eric Ludwig is a certified financial planner in Madison, WI primarily for a select group of successful professionals and business owners, who among other things aspire to a work-optional lifestyle.  Stockbridge has developed and refined a process to put all the pieces of that puzzle together and we call it the Stockbridge GPS process.  GPS stands for Goals, Planning, Strategy.

This is a guest post from momentumstrength.com

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