Fighting the Fed Fixation

Since the financial crisis, central banking has become a full-blown market obsession. How did we get here? Wall Street speculation on interest rates is certainly not a new phenomenon, but never before have investors hung so maniacally on the every word of central bankers. Are issues facing today’s market that different than ones faced by all markets in history, or is this new monetary policy compulsion simply a product of the proliferation in short-term focused financial media? Leon Cooperman, for one, is bemused by the fixation on the Fed and thinks the implications of rate hikes are misunderstood.

Sure, the scale of the Federal Reserve’s quantitative easing program was unprecedented, but so was the nature of the 2008 crisis. Yes, interest rates have stayed low for longer than most expected, but inflation and employment growth were lackluster until very recently. The new line trumpeted in the mainstream financial media is that the Fed has become “data-dependent.” When has the Fed ever NOT been data dependent? They didn’t move interest rates to zero-bound as some kind of sadistic experiment – they did so because they were the only game in town (in the absence of fiscal policy solutions in Washinton) to prevent the US economy from falling into a deep and long-lasting depression.

If you go back and watch episodes of the original Wall $treet Week with Louis Rukeyser, there are plenty of conversations about the Federal Reserve and interest rates. The difference is there was no 24-hour news cycle reporting every Fed Governor speech. While things like market structure evolve over time, themes driving financial markets will never change.

Born in 1943, Mr. Cooperman has been through his share of market cycles. He’s not one of the Wall Street millennials who has never seen a rate hike. And his CV isn’t bare, either. Cooperman is one of the most successful value investors of all-time, amassing a fortune that starts with a ‘B’ during his time with Goldman Sachs and now his own firm, Omega Advisors.

While there are plenty of intelligent observers expressing concern about the market’s potential reaction to rate hikes, it’s hard to argue with Cooperman’s points about Fed tightening fears being overblown. In fact, he thinks the bigger concern would be if the Fed stands pat. “If we’re sitting here a year from today and the Fed has not raised rates – that suggests there’s something wrong with the economy,” he said on today’s Wall Street Week. “The initial stage of rising interest rates are indicative of an improving economy, rising earnings, rising dividends. The market likes that. It’s only when the Fed starts to raise rates to levels that are competitive with the stock market returns that you have a problem.”

With respect to the prospect of forthcoming interest rate hikes, Cooperman cited [market technician Edson Gould’s] ‘Three Steps and a Stumble’ rule, which holds that equity markets are unlikely to suffer substantial setbacks until the Federal Reserve raises either the discount rate, margin requirements or reserve requirements three consecutive times without a decline.

Here’s Cooperman on Wall Street Week regarding the rate hike obsession:

“I’m very interested in this fixation about the Fed. Let me give you and your viewers some historical information. Since the mid 1950’s I think there have been eight business cycles. On average, the market peaked 30 months after the first Fed rate hike, and the shortest period of time was ten months. And those previous periods of Fed rate tightening didn’t start from zero…

Who thinks the market at 16.5 or 17 times earnings or a 2.1% 10-year government bond [yield] is discounting a zero Fed Funds Rate? It’s allowing for somewhat higher interest rates. Another statistic … on average after the first Fed tightening, one year later the market is higher by an average of a little under 10%.”

While the stock market is regarded as a leading indicator for the economy, with the jobs market currently humming along with a strong 280,000 reading for May, there is little to indicate risk of a return to recession. And while ZIRP has boosted asset prices, the relative lack of demand for credit despite an open spigot means Fed policy has not created a transitory and fragile economic boom that will be derailed by a gradual increase in interest rates.

As we mentioned in the Episode 4 newsletter regarding a potential Grexit, there is uncertainty about the implications of a rate hike from zero after six years of ZIRP because there is no precedent. However, the fundamental risks of such a scenario have significantly decreased in the last several years. The greatest risk at this stage could be the fact, given investors’ unhealthy obsession with the Fed, that a sharp sell-off following the first rate hike could become a self-fulfilling prophecy.

This feature originally appeared in the June 7, 2015 issue of the Wall Street Week Newsletter. Subscribe to the newsletter – it’s free.