Spread between 2-year yield and FF rate
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In 14 years of newsletter writing, I have so far been 100% accurate in predicting what the Fed should do. What the Fed actually DOES do, however, is quite often different from what it should do. Since the Fed cannot possibly cut rates any further than zero, most of the discussion of Fed policy has to do with when the Fed will start to raise rates again.
Exactly how public traders and investors would react to the news of a change in the FOMC's thinking would likely depend on how much foreshadowing the members of the FOMC did in speeches leading up to the action. A surprise hike, coming out of the blue, would likely have a bigger effect than one which had been subtly but repeatedly telegraphed.
Concerning how the market itself might respond is a bit more of an economic physics question, and thus easier to answer. Right now, the Fed has a lot of room to raise rates without being oppressive to the market. I like to look at the spread between the 2-year T-Note yield and the Fed Funds (FF) target. The 2-year seems to know what the Fed is going to do well before the FOMC itself becomes aware. The 2-year yield bottomed at 0.64% back in December 2008, when the FOMC dropped its target rate from 1.0% to "between 0% and 0.25%". The 2-year yield is now above 1.0%, and is thus saying that the Fed is keeping rates too low for too long.
It gave us that same message in 2003-04, but the Fed was not listening then, and the result was like feeding gasoline to the housing market inferno. Keeping the FF target rate below the 2-year yield is very stimulative to the stock market. Similarly, having a FF target well above the 2-year yield acts as a big depressant. If the Fed wants to get out of this cycle of giving the economy a sugar-rush and then crash, then setting the FF target where the bond market tells us it should be set would be much more appropriate, and would lessen the wild swings in both interest rates and economic activity. In other words, we don't so much need district governors setting policy as much as we need mechanical overspeed governors.
Had the FOMC started dropping the FF target from the 5.25% level back in 2006 when the 2-year yield started falling, then the puncturing of the housing bubble would (IMHO) been far more gentle. The longer that the FOMC leaves the target too low, the worse will be the magnitude of the next problem that is getting started now. Ironically, the Bernanke Fed gets a lot of credit for cutting rates rapidly in early 2008, while the Fed should more appropriately be given huge amounts of blame for leaving rates too high for too long. Given where the 2-year yield is right now, if I were made emperor of monetary policy I would raise the FF target right now to 0.5%. and then raise it again at the next FOMC meeting to 0.75%. Since the 2-year T-Note yield is just above 1%, a FF rate of 0.75% That would still leave about a quarter point worth of putting a thumb on the scale to help give more liquidity to the economy, but would lessen the risk of over-fertilizing. If anyone has Bernanke's ear, you can tell him to call me. We could even have a beer together, since that is now the trendy thing to do.
Editor, The McClellan Market Report