Fed Drum Roll

Here we go again with the debate over whether or not the Federal Reserve (Fed) should, could, will, or won’t raise rates in September. This interminable drum roll of a debate must come to an end.

The issue is that there is a distortion in the front end of the yield curve. It is due to the fact that the bottom end of Fed policy is zero. Every investor sees that distortion every time they receive a statement for a money market fund that pays 0.01% interest. That is true of the taxable, tax-free, and government-security-only money market funds. The return is 0.01% for investment cash stored, placed, held, or otherwise domiciled in the financial services arena.

It’s time to get away from 0.01% returns.

The Fed, its skilled staff, and members of the Federal Open Market Committee (FOMC) know a distortion when they see it. They also know that the US economy is in a less than robust, yet steadily improving, economic recovery that is generating very low inflation and continuous job creation somewhere in the vicinity of 200,000 to 250,000 nonfarm payroll additions each month.

One Fed hike to 50 basis points on IOER (interest on excess reserves) and one notch up on the reverse repo rate (RRP) puts the Fed and the markets in a position of achieving price discovery at the front end of the yield curve. When price discovery occurs and market forces begin to clear between the bottom-end RRP and the top-end IOER, there will be some adjustment in the federal funds rate. That rate will reveal the demand and supply of reserves tradable between RRP bottom and IOER top.

[Read: Plotting the Fed’s Baby Step 1/8 Point Hikes; Yellen vs. Greenspan “Measured Pace”]

Why do we need this liftoff of 0.25 points?

The issue is simple. The entire yield curve is impacted by the zero side. We are not getting full and complete price discovery at the intermediate-term and long-term levels because rates are anchored at the distorting zero-bound. Economies, markets, mortgages, building, rebuilding, refinance, growth – all require price discovery. Price discovery requires a system that allows some price to be set by supply and demand. That is why the Fed has to get away from zero.

My colleagues Bob Eisenbeis and Bill Witherell have written that the Fed’s impending rate move is not about China and currency reserves, negative interest rates in the Eurozone, or geopolitical pressures on the oil price. It is about getting to an operating structure with price discovery.

Let’s sum this up. In our view the risk in September is elevated if the Fed does NOT move. Should the Fed forgo a rate move of 0.25 points, inaction would relay a message to the markets that things are much worse than markets anticipate

My good friend Dr. Nariman Behravesh said, “It is the longest drum roll in history to get to a single 25-basis-point increase in interest rates.” Dr. Behravesh is right. It is time to lay down the drumsticks and seize the moment.

Cumberland Advisors believes that the Fed will hike 0.25 points before the end of this year. We would like for that move to come in September, and we think it will do so; but our strategic view is that a 0.25-point hike will come before the end of 2015. That is the basis on which we are proceeding with our investment strategy.

About the Author

Chief Investment Officer
David [dot] Kotok [at] cumber [dot] com ()
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