What Should the Fed Be Worried About?

You’re probably a little fed up with the Fed, but it’s worth paying attention to our nation’s central bank, even if it holds less influence than it would like to think.

Let’s talk brass tacks for a minute.

There are normally 12 voting members of the Federal Open Market Committee (FOMC): seven Board of Governrnor (BOG) members, the president of the Federal Reserve Bank of New York, and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis.

But because of three vacancies, there are only nine voting members. Early next year, the terms of two more officials will expire – including Fed Chair Janet Yellen.

The BOG members are appointed by the President of the United States and serve 14-year terms. Unless President Trump re-appoints Yellen, she is expected leave the Fed on February 1, 2018. And Vice Chairman Stanley Fischer’s term is up June 12, 2018.

I hope the Trump administration is working overtime to find candidates to fill the current three open vacancies, not to mention possibly another two next year! The FOMC is down by a quarter of its voting members and the BOG may only have two (of seven) left by this time next year.

Many of us are concernrned that Fed policies of the past decade are pushing us to a tipping point. The results from the past three interest-rate hikes aren’t very encouraging so far. If there’s any hope to see a substantial change of direction in the Fed during the Trump Administration, he needs to fill the vacant seats.

For the time being, stocks are still near all-time highs. I worry this will spawn complacency, even though bonds are acting like we’re on the precipice of a real crisis.

I’ve been writing for weeks about the fact that the yield curve is flattening… and that’s usually an ominous sign. When long-term rates drop below short-term rates, the yield curve is inverted. And when that happens, a recession is sure to follow. An inverted yield curve has correctly predicted all past recessions going back to the 1960s.

So why isn’t the Fed alarmed with the flattening yield curve? New York Fed President William Dudley said Monday that a flattening yield curve is not a negative signal for the economy.

In a word: Whaaat?

Well, that comment, along with his comment that halting rate hikes would imperil the economy, led to a short-lived Treasury bond sell-off. But buyers came back quickly, which led to new 2017 lows in yields within a couple days. It almost goes without saying, but here it is again: The Fed’s ability to move markets and market sentiment with well-placed quotes shrinks more and more by the day, taking its credibility along for the ride.

It’s no secret that Fed officials are puzzled as to why inflation hasn’t reached their 2% target. Chair Yellen continues to point out that unemployment is low unemployment and the economy is growing, a combination that, in theory, at least, should produce inflation.

The problem seems to be that the economy isn’t growing enough and wages aren’t growing fast enough, which keeps consumer spending down and corporate profits depressed. When companies aren’t expanding and making more money, wages won’t grow. It’s a vicious cycle!

Sure, the abnormally low interest rates of the past decade have allowed us to finance cars and homes on the cheap while fueling rising home prices and a surge in auto sales. But low interest rates haven’t seemed to translate into higher corporate profits via pricing power and higher margins.

Fed-enabled low interest rates translated into more stock buybacks and higher stock prices, though. And it’s not just stock prices but other asset prices as well.

After the first housing bubble popped in 2006-07, Fed policy is helping fuel another. Low interest rates and easy mortgage credit have helped pump demand. Prices have met or exceeded those in the last bubble, even though existing sales are still 20% lower and new home sales are 40% off of where they were at the peak of the last bubble.

You don’t need me to tell you that these are not good signs, no matter how you slice them.

The Fed wants us to believe that declining inflation, low wage growth, and overall low economic growth are just temporary, insisting its current rate-hiking path is the proper one to head off future spikes in wage growth and inflation.

But is the real goal to just take some air out of current asset bubbles?

That’s what I’m thinking. I believe the Fed’s current policy is meant to take some air out of the asset bubbles they’ve created, not to avert an overheating economy. The problem is that bubbles usually pop, and if that happens our central bankers will quickly reverse course.

If the stars don’t magically line up for the Fed (like a turnrnaround in retail sales, growing inflation, growing labor participation, and/or a slowly deflating stock and real estate bubble), the Fed could ultimately start cutting rates.

And if another financial crisis rears up, the Fed can forget about reducing its $4.5 trillion balance sheet. In fact, it may be forced to add to its balance sheet with more QE! Remember, the last Fed statement said as much.

Yellen has a lot to worry about between now and when her term is up early next year. I’m pretty sure she and her counterparts are crossing their fingers that nothing bad happens anytime soon.

I’m not sure if was Yellen’s comment earlier in the week about the unlikelihood of another financial crisis happening in our lifetime or just the fact that bonds were overbought. But, my Treasury Profits Accelerator readers just banked a near 73% gain yesterday! Not bad for a trade we were only in for eight days.

You can prepare for and profit from surprises in the financial markets, and specifically in the Treasury bond market with Treasury Profits Accelerator.

Lance Gaitan

Editor, Treasury Profits Accelorator

Lance Gaitan

Lance has a unique ability to find big gains in the most boring of market. He manages to turn sleeping giants into a monster gain-makers – some of the most profitable investment opportunities of a lifetime.