The Fed and Markets

January 30, 2014

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The Fed meets and Bernanke hands the baton to Yellen. Results materialize; new voters vote; the tapering process continues.

Tapering for the rest of this year and until our central bank becomes neutral seems a course increasingly etched in concrete. At the same time, the Fed (Federal Reserve) issued technical notes. One of those notes affirms the process by which they are preparing to reduce the size of the balance sheet and restore the management of an interest-rate policy as they move away from the zero bound.

That process is likely to occur in 2015 and 2016. The preparation is currently underway and is being refined. My colleague Bob Eisenbeis has written about reverse repos and the intricate ways in which monetary policy can utilize them. We will not repeat that here.

The more the Fed moves toward neutrality and then toward an interest-rate policy, the more the Fed reestablishes its historic role that includes suppression of inflation flares. The more the Fed proves credible in asserting that its target of 2 percent inflation is acceptable while a large inflation spike of the type we had in the 1970s is not acceptable, the sooner the bond market reaches a comfort level and stabilizes.

The Fed also reiterates an employment target because it is a dual-mandate central bank, charged with a dual focus on both inflation and unemployment rates. The Fed in its history has gone through all sorts of machinations to tie the two together. At the present time, the unemployment rate hovers above the Fed’s target, and the inflation rate lingers below the Fed’s target. Thus the Fed is in a place where it can still have an expansive monetary policy, but it is preparing for something less stimulative in the future.

Some expected the Fed to restructure the unemployment target to some lower number between 5.5 percent and 6 percent. In fact, the Fed may be considering reassessing the target in the near future. Some of the members of the FOMC (Federal Open Market Committee) have spoken openly about lowering that unemployment rate target. For the present, however, the 6.5 percent number remains the Fed’s “guidance.” The Fed has gone out of its way to argue that tapering is not tightening and to suggest that it will hold short-term interest rates very low for an extended period of time. Most observers, including ourselves, expect the short-term interest rate to be near present levels for the next two or more years.

The intricacies of central bank policy are not carried out in isolation. While our markets focused on the Fed’s report, we must note that other central banks in the world have had to raise interest rates to defend their currencies. In so doing, those central banks have triggered a mini crisis in the emerging-market space. We have seen dramatic central bank actions take place in South Africa, Turkey and India. And we are not ignoring actions in Argentina. That country has followed policies which brought on one catastrophe after another for the last century. Our fear is that a sequence of events in various emerging markets and among various currencies could lead to a contagion.

We have argued that contagion risk is higher than normal. We do not know when a contagion will occur. It is impossible to forecast the shock the day before it happens. One can however forecast rising contagion risk, and to this observer that risk does appear to be increasing.

At Cumberland, we continue to maintain a cash reserve and watch the stock market go through what we think are corrective convulsions. We expect volatilities in 2014 to be higher than in the last several years as our central bank tapers towards neutrality and as other central banks worldwide go through their own versions of these gyrations. We are not fully invested today.


The preceding is by David Kotok of Cumberland Advisors and has been reposted with permission of the author. The commentary is available at

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

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