What happens when the Fed stops raising interest rates?

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A reader asks:      What happens when the Fed stops raising interest rates?

Archer replies: Niall Ferguson recently wrote on Bloomberg that, “There is only one true law of history, and that is the law of unintended consequences.” When it comes to unintended consequences, the Fed is the acknowledged master.  

The implosion of a number of regional banks back in the spring is one example. The biggest bond market rout in 150 years is another. There will, no doubt, be others. One thing for sure, these will not be flagged in advance by the Fed’s myopic data-driven view of the world. But take a moment to look on the bright side. If the Fed is indeed done raising rates for this cycle, that is generally good news.

The markets seem to think so. In the days leading up and following the Fed’s early November confab stocks rallied after falling for three straight months. For the week the S&P 500 ended up nearly 6.0%, the best week so far this year. This was mostly unleashed by the perceived shift in Fed policy, a drop in the yield on 10-year treasuries, and, to some extent, by an improved outlook for earnings.

For those who like these kinds of things, FactSet provides a handy look at corporate profitability. As of November 3, 3Q S&P earnings were up 3.7%, the first quarter of year-over-year growth since the third quarter of last year. The forward 12-month P/E for the S&P 500 was 17.8, below the five year average of 18.7 but slightly above the 10-year average of 17.5.

Seems like generally good news, but of course not everyone is sanguine. British investor Jeremy Grantham, for one, remains locked in perma-bear, fin de siècle mode, suggesting that stocks are overvalued by as much as 50%. But an interesting counterpoint is offered by another Jeremy – Jeremy Siegel, not usually a font of positivity. By Siegel’s lights, U.S. stocks offer “great long-term values” as measured by earnings yield – the hypothetical inflation-adjusted returns compared to bonds. At the moment Siegel calculates the earnings yield on stocks is around 6.0% compared to an adjusted rate of about 2.4% for the bond market.

That there is a difference of opinion as to where things are going is not surprising. Much of this turns on the always important question of “valuation” – something that seems like it should be obvious but is not.

As FactSet notes, the forward p/e for U.S. equities is not too different from where it has been of late, at around 17 (though interest rates were much lower during that period). It has been much higher, as high as 45x during the Dot Com bubble at the turn of the century. And it’s been lower, too.

But of course the forward estimates are just that: estimates. In the real world, stuff will happen. Still we do seem to have arrived at some sort of inflection point. The wild card here may be A.I., a technology that is everywhere in the news but nowhere understood. It is the “blockchain” of the moment; everything is said to be “powered by A.I.” but no one really knows what that means.

Like computers and the early days of the Internet, there is a lot of hype but there is substance, too. But unlike say those innovations, A.I. is an embedded technology; it’s not obvious where it’s at work or what it’s doing. And that brings us back to Niall Ferguson. In his Bloomberg piece, he flags the national debt as a likely source of “unanticipated consequences.” He may be right, but if and when that happens, contra Ferguson, it will be the most anticipated disaster in history. As he notes elsewhere in the piece about the recent Fed moves, “Nobody could have predicted the Treasury market’s collapse of the last two years — apart from every critic of artificially low interest rates since John Locke.”

But A.I. and iterative learning are something new. For good or ill, and probably both, they will take us places we haven’t been before and are likely to do it faster than the previous generation of disruptive technologies – i.e. electricity at the start of the 20th century.

To illustrate: a friend recently mentioned to a young acquaintance that she was travelling to Europe and that the time there was six hours ahead. “Wow!” said the kid. “You’re going to be living in the future!” Exactly.

Woof.