Preparing for a Rainy Day

Tracking the U.S. Federal Reserve’s outlook on monetary policy these days feels an awful lot like watching a handful of balls bouncing around an old Japanese Pachinko game. For those unfamiliar with the Pachinko game, a player launches a series of stainless steel balls into a vertical playing surface. These balls haphazardly cascade down a maze of patterned pins, bells, and levers affixed to the face of the game to eventually settle at the bottom of the machine.

Comparing the monetary policies of the most powerful central bank in the world to a child’s game or gambling machine is not a particularly kind analogy and is not meant to imply that the U.S. Federal Reserve Board of Governors is permitting randomness to determine U.S. interest rate levels. Yet few could argue that the Fed’s recent record on forecasting interest rate policies has been anything but stable.

Take, for instance, the series of Federal Open Market Committee’s policy statements since raising interest rates at the end of last year. In a unanimous vote to raise the federal funds rate from 0.25% to 0.50% in December 2015, the committee referenced “considerable improvement in [the] labor market” and “[reasonable confidence] that inflation will rise, over the medium term, to its 2 percent objective.”1

Striking a much more dovish tone one month later, the January 2016, FOMC policy release left rates unchanged, citing increased concerns over structural adjustments in China and oil price volatility. In effect, the committee reversed its tightening bias by stating the federal funds rate is likely to remain, for some time, below levels that will warrant only gradual increases in the Federal Funds rate.2

Fast forward to Chairman Janet Yellen’s May 25, 2016, speech at Harvard University, when she confirmed a recent chorus of FOMC committee member speeches suggesting higher overnight rates “in the coming months,” implying stabilizing markets and reduced global volatility would support the argument for higher interest rates.3 Under the premise that a rotation in the global economy occurs about as quickly as a turn in an ocean container carrier, it seems plausible that the U.S. Federal Reserve may have other motives for abruptly returning to its tightening monetary bias.

Data Dependency
Since summer of 2014, the U.S. Federal Reserve has encouraged a philosophy of “data dependency” in making monetary policy decisions.4 Chairman Yellen’s term thus far can be characterized by a particular data focus on employment, as her public statements have tended to lead with comments regarding U.S. employment and labor utilization.

Chairman Yellen’s recent hawkish statements may very well be in response to improving headline unemployment rates within the United States. Based on reported figures for May 2016, the unemployment rate of 4.7%5 could certainly provide cover for the Federal Reserve to raise interest rates, particularly relative to unemployment rates during the credit crisis (Figure #1).

Fig. #1
Unemployment Rate: Seasonally Adjusted
Jan. 2006 – May 2016

Source: US. Bureau of Labor Statistics, Civilian Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis, June 7, 2016.

As most Daily Pfennig® newsletter readers will be quick to point out, this unemployment rate overlooks one important aspect of the labor force: Namely, a record 94.7 million employees no longer included in the unemployment calculation. In a similar sign of structural weakness, the labor participation rate has now fallen to a nearly four-decade low, most recently reported at 62.6% (Figure #2).

Fig. #2
Labor Participation Rate – Seasonally Adjusted
Jan. 1976-May 2016

Source: US. Bureau of Labor Statistics, Civilian Labor Force Participation Rate [CIVPART], retrieved from FRED, Federal Reserve Bank of St. Louis, June 7, 2016.

It would be erroneous to believe that the FOMC has overlooked, or does not appreciate, that these characteristics of the labor market are not particularly strong. Despite our limited ability to read directly into the minds of the FOMC voting members, it seems more likely that the Fed has chosen to place greater emphasis on an improving headline number when considering a tightening interest rate bias, rather than the structural issues influencing the labor market, for reasons outside of domestic fundamental factors. A more sensible explanation for the FOMC’s move towards a tightening bias within the current environment may be the Fed’s desire to increase flexibility in setting monetary policies, if or when the Fed would need to return to a more accommodative environment.

Keeping Your Powder Dry
Clearly, recent domestic economic growth does not appear characteristic of an environment warranting a higher interest rate environment (Figure #3). For the Federal Reserve to consider raising interest rates into an ostensibly slowing U.S. economy, the committee members may foresee some longer-term potential for greater economic volatility.

Fig. #3
Gross Domestic Product – Seasonally Adjusted
Q1 2010 – Q1 2016

Source: US. Bureau of Economic Analysis, Gross Domestic Product [A191RP1Q027SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis, June 6, 2016.

Yet with current short-term interest rates remaining near zero, the Fed has little flexibility to reduce interest rates, save for joining Japan and the European Union in moving toward a negative interest rate policy (NIRP). The FOMC may also face a short-term window of opportunity to make changes to its monetary policy when considering the presidential election later this year, preferring to maintain an impartial appearance in the months immediately ahead of the November election.

So if the Federal Reserve is planning to keep its powder dry, shouldn’t investors be considering the same? Granted, individuals do not have the same capacity as the Fed, but do have other options for planning ahead, including considering hard commodities such as gold and silver.

In a recently published commentary for CNBC, EverBank World Markets President, Chris Gaffney, discussed how a near-term increase in overnight interest rates by the Federal Reserve might offer an opportunity for investors to initiate or add to precious metal holdings.6 Chris referenced the uncorrelated nature of the metals complex to other asset classes, as well as the potential benefit to holding these investments as catastrophic insurance during periods of elevated volatility. Citing first quarter performance of the S&P 500 down 3.2% versus a 16.7% appreciation in gold,7 Chris concluded that investments in gold should be considered for most well-diversified portfolios. Moreover, investors with existing holdings in gold may want to also consider positions in silver, with current prices remaining at attractive values relative to gold prices.

Rainy days are inevitable for investors. But planning for those days through investments in non-correlated or insurance investments may help portfolios withstand the worst of the market volatility. And if the Federal Reserve is seemingly preparing for an unforeseen event, perhaps investors should as well.

Until the next Daily Pfennig® edition…

Tim Smith
Vice President
EverBank World Markets, a division of EverBank