On the other hand, look at what has transpired when the Fed withdraws stimulus (a.k.a. “de facto tightening”). The sharp increases in the overnight lending rate in 1999 required little more than 8 months before the Dow Industrials descended 31.5%. (The Dow was the baby of the benchmarks. The S&P 500 fell by 50% whereas the NASDAQ fell 76%!)
One might be predisposed to giving the Fed “credit” for tightening credit at a remarkably slow and predictable pace of just 0.25% 17 times from the 1% level between mid-2004-and mid-2006. The bear market response did not come for another 39 months. Nevertheless, the eventual increases in the cost of credit caused real estate sales to stall/decline long before ex-financial U.S. stocks began getting the message. While neither the Great Recession nor one of the worst bear market collapses on record are a function of the Fed’s tightening cycle alone – while the slow pace of tightening kept bull market dreams alive for longer than they might have otherwise – the Fed does not escape scrutiny. The relatively low cost to borrow-n-spend circa 2001-2003 coupled with the slow pace of repricing circa 2004-2006 helped create a housing bubble that was certain to burst.
So what, then, has the Fed accomplished with seven years of zero percent rate policy? For one thing, when the real price of money is negligible, borrowers (i.e., individuals, families, businesses, governments) borrow beyond their means and push the consequences out into the future. In fact, according to McKinsey, debt in industrialized nations like the U.S. has been growing at a rate of 5.3%. GDP? 2.2%. The growth of global debt versus global GDP is even more discouraging.
The only way to service ever-increasing debt with exceptionally modest economic growth is with unusually low rates. That is the big reason why market-based securities — stocks, currencies, commodities, bonds — are not sure what to make of the next Fed tightening cycle. Granted, one might be encouraged by the 39-month bull market stretch that followed the last campaign’s pace of quarter-point hikes. On the other hand, the bull market at the time had barely passed two years when the Fed acted in 2004 and the 10-year yield was at 4%. Today? The Fed has yet to act after seven years on the sidelines, the 10-year is near 2.25% and the bull market is more than six-and-a-half years old.
It follows that the Federal Reserve is unlikely to have as much room to raise its overnight lending rate and it may not have enough time before inverted points along the yield curve, a bear market, a recession or all of the above. A quarter point move at every meeting? Risk assets would likely have a conniption fit. One quarter point bump every other meeting if data is supportive? Potentially better. One eighth of a point every meeting or every other meeting? Obviously more desirable.
Here’s what it comes down to, then. The slower the pace of the Fed campaign, the greater the duration of the current bull in stocks.
Those momentum players who are looking to wring out gains from higher borrowing costs can look to regional banks. The SPDR KBW Regional Banking ETF (KRE) has never looked better relative to the S&P 500 SPDR Trust (SPY).
On the flip side, those of us who do not believe the economy is as strong as the October jobs report seemed to indicate expect more Fed-induced volatility. I continue to maintain a 60% (mostly large-cap domestic), 25% bond (mostly investment grade) and 15% cash/cash equivalent mix for the majority of Pacific Park Financial’s moderate growth and income clients. Prominent stock ETFs include Vanguard Total Stock Market (VTI), iShares USA Minimum Volatility (USMV) and SPDR Select Sector Technology (XLK). Prominent bond holdings include iShares 7-10 Year Treasury (IEF), Vanguard Total Bond Market (BND) and SPDR Nuveen Barclays Municipal Bond (TFI).
You can listen to the ETF Expert Radio Show “LIVE”, via podcast or on your iPod. You can follow me on Twitter @ETFexpert.