The reason the rate hike announced by the Federal Reserve this week became so certain, so early, is that after it raised rates in December, financial conditions actually became looser, not tighter.
Here’s a chart of what happened, along with the S&P 500 index:
Morgan Stanley Financial Conditions index and S&P 500
“Financial conditions” is a broader measure than simply the Fed funds rate, and adds the level of long term interest rates, the level of share prices, the size of credit spreads, the value of the currency and other things that affect the availability of credit.
It’s also going to be an indicator of the tension between Donald Trump and Janet Yellen.
Trump is trying to pump up the economy to Make America Great Again (MAGA), with corporate tax cuts and infrastructure spending, and the stockmarket is responding to that. The Fed is trying to do the opposite.
The last time something like this happened was 2004-2007, when the Fed raised interest rates 17 times in a row, from 1% to 5.25%, yet financial conditions actually got looser because the stockmarket rallied, bond yields fell and banks were falling over themselves to lend against housing.
With the benefit of hindsight, the Fed should have hiked more aggressively to head off the housing bubble that developed, and then crashed.
The main reason financial conditions eased in December just passed is that the stockmarket rallied on Trump and the general reflation trade.
I reckon the Fed will have learned its lesson from the 2007-08 disaster and if it looks like the “MAGA trade” is going to be successful at offsetting its efforts to tighten financial conditions this year, the Fed will raise rates much more aggressively than everyone expects.
In other words, one of the key things for investors to watch this year – apart from how the Chinese economy unfolds (see below) – is how this battle between Janet Yellen and Donald Trump plays out.
It’s two of them sitting on a horse, Trump whacking its rump and Yellen pulling on the reins. The more Trump whacks, the more Yellen will pull. What will the nag do? Nothing probably.