The Federal Reserve finally mustered the courage to end its radical zero-interest-rate-policy experiment this week. Its quarter-point rate hike announced on the seventh anniversary of ZIRP kicks off the long road to normalization. This leaves the stock markets and gold in unprecedented uncharted territory. The Fed has never before attempted to exit ZIRP, let alone in the midst of such extremely distorted markets.
The Fed's ZIRP saga symmetrically ended 7 years to the day after it began way back in mid-December 2008. That was just after the dark heart of that year's once-in-a-century stock panic, which struck terror into the Bernanke Fed. The benchmark S&P 500 broad-market stock index (SPX) had plummeted 30.0% in a single month in October, and then plunged another 11.4% from those brutal lows in the subsequent month.
The Fed deeply feared the sudden loss of 3/8ths of Americans' stock-market wealth would cast the US into a new Great Depression. History has proven the stock markets have a powerful wealth effect on consumer spending, which drives over 2/3rds of the US economy. As stock markets drop, people feel poorer and more financially vulnerable so they slash their own purchasing. That slows the entire economy.
So in late October 2008 just a couple days after that initial 30% SPX plunge, the Fed slashed its federal-funds rate by 50 basis points to 1.00%. But this frantic easing proved insufficient to stop the panicked mass exodus from stocks, so the Fed slammed its monetary accelerator to the floor at its next meeting in mid-December. It gashed the FFR an extreme 100bp lower to zero for the first time in the Fed's 95-year history!
The Fed promised this was a temporary crisis measure, as ZIRP is extremely abnormal and unhealthy for the markets and economy. Zero rates destroy the normal balance between saving and borrowing, radically distorting capital allocations. The longer rates are forced down to artificial lows, the greater the warping from normal market conditions. Yet the Fed still inexplicably left ZIRP in place for 7 freaking years!
The momentous decision to normalize rates
its long-overdue decision to tentatively start normalizing rates this week is truly momentous. Looking back on this in future years, the end of ZIRP will likely prove to be one of the most-important events in US financial-market history. Its implications for the global markets, including the US stock markets and gold, are profound. As both ZIRP and its end are wildly unprecedented, the markets are entering a new frontier.
This week's rate hike may only have been 25bp, but its impact will be vast beyond its deceivingly-trivial headline size. Technically the Fed's ZIRP experiment wasn't quite zero, as the Bernanke Fed all those years ago established a federal-funds-rate target range from 0.00% to 0.25%. The actual average FFR in those 7 years since was 13 basis points, not quite zero. This helps frame the enormity of this week's hike.
Wednesday, the Yellen Fed established a new FFR target range of 0.25% to 0.50%. So even at the low end of 25bp, this essentially doubles the overnight interest rate of the past 7 years! And if the Fed again forces the FFR to the midpoint of its new target range, it would nearly triple to 38bp. A doubling or even tripling of short-term rates is an astounding hike, especially after they've had so long to become entrenched.
The Fed actually doesn't directly control the federal-funds rate, as it's technically a free-market interest rate determined by federal-funds supply and demand. That's the key market where commercial banks borrow and lend their cash reserve deposits held at the Fed on an overnight basis. In order to bend the FFR to its will, the Fed has to actually directly buy and sell federal funds through open-market operations.
After 7 years, many trillions of dollars of short-term debt has been priced for a ZIRP world. This gives zero rates extraordinary inertia that won't be easy to overcome. To force the FFR to double or triple, the Fed is going to have to suck out hundreds of billions of dollars of liquidity from the markets. At least one elite Wall Street bank claims the Fed will have to remove over a trillion dollars to implement this ZIRP-slaying hike!
Quarter point hike actually a gargantuan, possibly epic move
So a quarter point coming off of 7 years of ZIRP is gargantuan, maybe even epic. Its implications for the financial markets won't be fully apparent for weeks or months. Wednesday's kneejerk euphoria from stock traders immediately after this universally-expected hike announcement was terribly misplaced. Even Janet Yellen herself warned that monetary policy takes time to affect future economic outcomes.
And despite the end of ZIRP being a critical step towards normalizing the Fed's extreme easing since the stock panic, it is only an initial one. This chart looks at the federal-funds rate and Fed balance sheet over the past 35 years. Just as ZIRP was a radical departure from all historical norms on the rate front, the Fed's associated quantitative-easing bond monetizations were even more extreme on the BS front.
For a quarter century before 2008's stock panic and subsequent Fed panic to ZIRP, the federal-funds rate averaged 5.5%. Even in the decade ending in 2007, which saw extremely low rates as well with the Fed fighting a new stock bear, the FFR averaged 3.8%. So the Fed's normalization of interest rates is barely starting! Interestingly, this latter pre-ZIRP average FFR aligns right with Fed officials' own expectations.
The Fed's elite monetary-policy-setting team, the Federal Open Market Committee, meets 8 times per year. Every other meeting is followed by a Janet Yellen press conference, and includes a separately-published Summary of Economic Projections. This document includes a scatter plot showing where all FOMC members and regional Fed presidents expect the federal-funds rate to be in subsequent years.
Traders closely watch this chart they call the "dots", as it reveals the expectations of the handful of Fed officials who actually set monetary policy. And in this week's version reflecting the end of ZIRP, these guys expect the FFR to be back above 3.25% by 2018 and return near 3.50% over the longer run after that. This would take 13 more 25bp rate hikes to achieve, so this new Fed tightening cycle is just starting.
Provocatively the Fed may never be able to fully normalize though. One of ZIRP's worst misallocations of capital occurred at the US government, where record-low rates encouraged exploding borrowing by the Obama Administration. The resulting record federal-debt levels mean interest payments at historical normal rates would literally bankrupt the US government! The Fed's US debt bomb makes normalization impossible.
Nevertheless, interest rates are still heading higher in the coming year. The dots show Fed expectations for next year's FFR between 1.00% and 1.25%. And assuming the markets actually cooperate enough to indeed allow the Fed to hike to 125bp, that would leave the FFR nearly an order of magnitude higher than the past 7 years' 13bp! So even a weak partial normalization has vast implications for world markets.
Fed's balance sheet explosion post-2008
And while we're here, check out the Fed's epic balance-sheet explosion since the stock panic. Once the Fed forced short rates to zero, it couldn't cut any more. Economists call this hitting the zero lower bound. But since the Fed wanted to keep easing beyond ZIRP, it started quantitative easing in concert. QE is creating new money out of thin air to buy bonds, the mechanism the Fed used to force down long rates.
By printing money to purchase bonds including US Treasuries, the Fed artificially increased demand for these bonds. That drove up their prices which pushed down their yields. The Fed used QE to actively manipulate the long end of the yield curve just like ZIRP manipulated the short end. FOMC statements since 2008 brazenly admitted forcing long rates lower was QE's goal, it was certainly not done in stealth.
The Fed conjuring up new money to buy trillions of dollars of bonds was classic debt monetization, the stuff seen in banana republics before their monetary systems collapse. All those bonds ballooned the Fed's balance sheet incredibly as they piled up there. In 2007 which was the last normal year before 2008's stock panic, the Fed's balance sheet averaged $830b. Its latest read was a staggering $4442b!
If the Fed's balance sheet had grown at its normal rate over the last 7 years, it would only be around $1.2t today. Instead it has multiplied 5.4x higher to $4.4t, thanks to extreme QE debt monetizations up over $3.6t! A full normalization of the Fed's balance sheet would require it to sell those trillions of dollars of monetized bonds to remove that vast new money supply. Sooner or later, the Fed has to start unwinding QE.
And provocatively, this week's FOMC statement paved the way for that. For the first time ever, the Fed started to signal the coming reduction of its balance sheet! It said it anticipates maintaining its massive monetized bond holdings "until normalization of the level of the federal funds rate is well under way." Just like it did before ending ZIRP, the Fed just started laying the psychological groundwork for reversing QE.
The financial markets have never before witnessed a Fed liftoff from the zero lower bound, let alone a wildly-outsized Fed balance sheet contracting. The slow normalization of rates and money supplies will begin to reverse the radical market distortions created by them. And that has enormous implications for the global markets, including the US stock markets and gold. Investors need to take Fed tightening very seriously.
The primary market impact of those extraordinary 7 years of ZIRP and QE was an astonishing levitation of the US stock markets. The correlation between the S&P 500 level and the size of the Fed's balance sheet since early 2009 is stellar. The stock markets rallied dramatically whenever the Fed monetized debt, then corrected sharply once those new monetizations abated. Stock markets' dependency on Fed easing is ominous.
ZIRP and QE conspired to artificially boost the stock markets from multiple fronts. With both short and long interest rates forced down to contrived lows, investors were coerced to deploy capital in stocks just to survive a record-low-yield world. ZIRP itself greatly contributed to the stock-market levitation through the mechanism of record-low corporate borrowing rates fueling universal enormous corporate stock buybacks.
Underlying economy riddled with mal-investment, stock market risks
Since ZIRP destroys the healthy balance between savers accumulating capital and debtors seeking to use it, the underlying economy isn't healthy. It's riddled with all kinds of mal-investment in things the world doesn't need, which retards economic growth. So US companies had a tough time growing their revenues during the zero-rate era. Underlying demand for their goods and services just wasn't strong enough.
So they resorted to the pure financial engineering from stock buybacks to foster the illusion of rising profits. Elite US corporations borrowed trillions of dollars near record-low rates in the ZIRP era to use to buy back their own stocks. This direct purchasing of shares greatly boosted stock prices, as buybacks have been the primary source of stock demand in recent years. ZIRP fueled the stock-market levitation!
Buybacks naturally reduce the number of shares outstanding, which creates the appearance of growing profitability. Investors and analysts always look at earnings per share instead of total profits. Spreading actual earnings across fewer shares boosts EPS, so stock buybacks proportionally raise this dominant profitability benchmark. Higher EPS also lowers valuations, since it is the denominator of price-to-earnings ratios.
By ratcheting up corporate borrowing costs, the end of ZIRP really tilts the economics unfavorably for debt-financed stock buybacks. Waning buybacks will torpedo one of recent years' most important if not the most important source of overall stock demand. That buyback slump alone will almost certainly slay the Fed's extraordinary stock-market levitation since early 2013. Slowing buybacks will also increase valuations.
With the buyback-fueled shrinkage in outstanding share counts greatly abating or even reversing, the corporate earnings are going to be spread across more shares lowering EPS. Lower earnings per share forces P/E ratios higher, leading to higher stock-market valuations. This is a menacing portent with the average P/E ratio of the SPX component stocks recently soaring near 26x, already challenging 28x bubble territory!
And right as stock investors are confronted with waning corporate-buyback demand, weakening EPS profiles, and higher P/E ratios, ZIRP will be boosting competing yields in bonds. This will lead legions of yield-seeking investors forced against their wills by ZIRP into dividend-paying stocks instead of bonds to start migrating back into bonds. That will put even more selling pressure on wildly-overextended stock markets.
So contrary to the euphoric kneejerk reaction of stock traders Wednesday on the end of the ZIRP era, it is very bearish for today's super-overvalued stock markets! Extreme Fed easing directly fueled the SPX levitation beyond 1500 starting in early 2013, so this new Fed tightening is likely to reverse those artificial gains since. The first Fed tightening cycle launched since June 2004 is not something to trifle with.
Traders' bullish stock-market psychology is also exceptionally vulnerable today due to an expectations mismatch. This latest FOMC meeting's dots imply Fed officials see 4 or 5 more 25bp rate hikes in 2016, but the markets are currently pricing in just 3 or less. So there's a mounting chance of a big downside shock as traders inevitably come around to the fact the Fed is far more hawkish than they are betting on.
Speculators and investors can bet on or hedge against this coming cyclical stock bear market that Fed tightening will exacerbate using the leading SPY SPDR S&P 500 ETF. Buying long-dated SPY put options allows speculators to game lower stock prices, and will help investors offset some of the resulting losses to their portfolios. Cash and gold positions should also be accumulated leading into a stock selloff.
And that brings us to gold, a four-letter-word these days and the most-hated asset class in the world. While gold held on to a nice rally the day the Fed hiked rates, it was promptly pounded the next morning. American futures speculators have long assumed that zero-yielding gold will be a lot less attractive in a post-ZIRP world. They've been aggressively shorting it accordingly in anticipation of this very event.
A major side effect of the Fed's stock-market levitation of recent years fueled by ZIRP and QE was the seduction of capital away from other markets. As stock markets did nothing but rally on balance thanks to endless Fed-official jawboning implying a Fed Put backstopping the stock markets, investors pulled capital from other assets to chase stocks. And gold was a major casualty, suffering withering investment demand.
Stock traders in particular fled gold by dumping their shares in the flagship SPDR Gold Shares gold ETF at far faster rates than gold itself was being sold. This epic record differential GLD-share selling in 2013 forced this ETF's managers to dump vast amounts of gold bullion into the markets to raise the necessary cash to meet redemptions. This flood of gold emboldened futures speculators to short gold at extreme record levels.
That epic shorting flowed and ebbed during the stock-market-levitation years, periodically surging to new peaks that forced gold to artificial new secular lows. These lows weren't fundamentally righteous because short sellers effectively borrow gold they don't own in order to sell it. Every ounce shorted has to soon be repurchased to close those shorts. So gold-futures shorting is guaranteed proportional near-future buying.
This epic record gold-futures short selling was supremely irrational in the midst of the largest inflationary event in world history in the form QE's exploding debt monetizations. Soon these speculators with their extreme leveraged short positions will realize this new Fed tightening cycle isn't going to drive gold to zero. Then they will rush to cover. History is simply not on their side, gold tends to thrive in Fed-rate-hike cycles!
Last week I did a comprehensive study showing zero-yielding gold's performance in every Fed-rate-hike cycle since 1971. During the exact spans of all 11, gold achieved an outstanding average gain of 26.9%. It rallied in the majority 6 of these, for awesome average gains of 61.0%! Gold surged the most in Fed-rate-hike cycles when it entered them near major lows, and their pace of hikes was the most gradual.
And that's exactly the situation today, with gold just off 6.1-year secular lows entering what is promised to be the most gradual rate-hike cycle in Fed history. But even when gold enters rate-hike cycles near major highs and they are fast and aggressive, its downside risk remains asymmetrically small. During the other 5 rate-hike cycles of the modern era, gold only lost 13.9% on average. Rate hikes are bullish for gold.
The last one bears this out too. Between June 2004 to June 2006, the Fed made 17 consecutive rate hikes which more than quintupled its federal-funds rate to 5.25%. If rate hikes were indeed bearish for gold as futures speculators assume today, gold should've been obliterated in such a relentless barrage blasting the FFR so high. Yet over the exact span of that last rate-hike cycle, gold surged 49.6% higher!
Gold runs counter to stocks
How can this be with American futures speculators so convinced rate hikes are gold's nemesis? Gold is a unique asset that moves counter to stock markets, which seriously suffer when they enter rate-hike cycles at lofty overvalued levels. So gold investment demand for prudent portfolio diversification surges as stocks weaken. The room for this phenomenon is vast this time given today's radical gold underinvestment.
So investors and speculators alike can position for this newest Fed-rate-hike cycle ending the ZIRP era by buying physical gold bullion or GLD shares. While gold's coming gains as investors start to return will be excellent, they will be dwarfed by the left-for-dead stocks of the elite gold miners. They are trading near fundamentally-absurd 13-year secular lows today, a ludicrous disconnect from their current profitability.
With the first rate-hike cycle in nearly a decade upon us, and the first time the Fed has ever attempted to normalize out of ZIRP, the markets are in extreme uncharted territory. It has never been more important to do your own homework instead of blindly believing the mainstream media's perma-bullish hype that will lead lambs to the slaughter. This starts with cultivating an essential contrarian mindset on the markets.
The bottom line is a whole new market era is upon us with the end of ZIRP. The Fed has never before tried to normalize rates out of ZIRP, so this new rate-hike cycle is utterly unprecedented. It is certain to have a vast impact on the financial markets, which won't become fully apparent for weeks or months yet. And this is only an initial step in the long road of reversing the Fed's extreme monetary policies since the panic.
Because the stock markets were artificially levitated by the epically-easy Fed in recent years, a tightening Fed is almost certain to reverse most of their fundamentally-unjustified ZIRP-fueled gains. Traders need to prepare for a new bear market in stocks. And since gold moves counter to stock markets, investment demand is going to return driving its price much higher in the coming years as the Fed normalizes rates.
Adam Hamilton, CPA
December 18, 2015