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Chart In Focus

Bond Market Knows What Fed Should Do

Chart In Focus
September 22, 2016

This article first appeared in McClellan Market Report #515, published Sep. 21, 2016, and reflects a theme we have reported on multiple times before. 

We have an unblemished 21-year track record of predicting what the Fed should do, with 100% accuracy.  What the FOMC actually does is often different from what it should do.  As of the Sep. 21 FOMC meeting announcement, the Fed has missed another chance to do the right thing. 

There is only one reason why the FOMC should ever change the Fed Fund target rate, and that is if the rate is in the wrong place.  Deciding what is the right or wrong rate is really difficult to do if all you do is look at economic data and complex models with Greek-letter math.  It is a lot easier if you just look at the bond market. 

We have long held the belief that the FOMC should just outsource the task of setting the Fed Funds rate, and give that job over to the 2-year T-Note yield.  The chart above compares those two, and makes the point that the further apart they are, the bigger the problems that the Fed is creating.  Problems can result from being too restrictive, or too stimulative.  Right now, they are being too stimulative (and punishing savers). 

This point is perhaps easier to see in the next chart. It looks at the raw percentage point spread between the 2-year T-Note yield and the Fed Funds target.  Right now the 2-year is above Fed Funds, and so it is a positive spread.

Spread between Fed Funds target and 2-year T-Note yield

To reveal the effect of that stimulus, we compare it to the NYSE’s A-D Line, which is the best indicator of market liquidity that we know of.  When the Fed is being stimulative by keeping the Fed Funds target below where it ought to be, that tends to create excess liquidity and push up the A-D Line.  But when we get conditions like 2000-01 and 2006-08, when the Fed is being overly restrictive, then that creates a rough time for the A-D Line, and for the economy overall.

There is one period in both charts when the Fed appears to have been “just right” about setting the Fed Funds target very close to the 2-year T-Note yield, and that was in 2011-13.  But this seemingly correct interest rate policy was more of a case of QE pushing the 2-year T-Note yield down far below where it rightfully should have been, thus shooting the messenger and losing the message about what interest rate policy should be.

The Fed now seems to be done with QE, and the 2-year rate has been rising.  The FOMC should follow suit, and move the Fed Funds target closer to where the 2-year T-Note yield is saying is an appropriate rate.  The Fed should then adjust further as the 2-year rate moves around.

The downside of adopting this policy would be that the various Fed officials would not get to feel as self-important, and perhaps we would not have to pay for their travel expenses to visit Washington, DC 8x per year for the critical FOMC meetings.  Missing out on that expenditure, and taking down their sense of self-worth, is a small price to pay in order to get the Fed to stop jerking around the economy and markets.

I am willing to allow them to pay that price.  

Tom McClellan
Editor, The McClellan Market Report

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